Section 83(b) Election: What Every Start-Up Founder and Employee
with Stock Option (RSU) Must Know
If you are a founder of a start-up and you believe your company will go big, or if you simply receive stock option from your employer you have to know about IRC Code Section 83(b). You need to consult with your CPA promptly upon receiving the stock option to see if 83(b) election is the right move for you.
Section 83(b) election must be made within 30 days from the date you receive stock option subject to vesting.
If you do not make the election, there is no tax consequences on the date of receiving/acquiring the stock option. Once the option is vested, you are required to report its Fair Market Value over your basis as your ordinary income and pay the tax on it. If you decide to hold on to your stock, it will be treated as a Capital Asset once it is vested. If you hold your capital asset for at least one year, upon the sale of your capital asset you will be paying tax with the preferential tax rate (0, 15, and 20%). So you will pay ordinary income tax once the stocks are vested, and capital gain tax once you sale your stocks.
Now, if you make the 83(b) election within 30 days of receiving the stock option, the downside is that you have to pay the ordinary income tax at the time you receive the stock option. But the reason most entrepreneurs make the 83(b) election is that once you make the election, your stocks are considered capital asset, and there is no tax consequences at the time the stocks are vested. Once you sell your stocks (most probably is well over one year after you made the 83(b) election) you will pay only capital gain tax on it. This how smart start-up founders in Silicon Valley and elsewhere save millions in taxes.
Let’s show this in an example: A is an employee in a start-up and his employer on 01/01/2019 gives him 100,000 stock option, vested in 3 years. At the time of granting this option, since the company is brand new, each stock worth $2. Three years later on 01/01/2022 when the stock option is vested, each stock worth $50. A sells the stocks the earliest that he can enjoy the long term capital gain rates.
Scenario 1: A does not make the 83(b) election. Here is the tax consequences at each date:
01/01/2019: No tax due
01/01/2022: A must pay ordinary income tax on $5,000,000 (assuming the highest tax bracket is 40%, A must pay $2,000,000 in taxes). A’s basis in the stocks is $5M and stock are considered capital asset from now on.
01/01/2023: A sells the stock for the total of $10,000,000. He recognizes $5,000,000 long-term capital gain, and pays LT capital gain tax of (assuming the rate is 20%) $1M
So overall A pays $3M in taxes.
Scenario 2: A makes the 83(b) election:
01/01/2019: A must pay ordinary income tax on $200,000. (Assuming he is still on the highest tax bracket) his tax obligation upon receiving the stock option is $80,000. Stocks are considered capital asset from now on.
01/01/2022: No tax due. However, A can sell the stocks at this point and enjoy the capital gain lower rates, instead of waiting for another year like in Scenario 1.
01/01/2022: A sell the stocks for $5,000,000, recognizes $4.8M and must pay capital gain tax of $960,000. Alternatively, A can hold on the stocks and sells them on 01/01/2023 for $10,000,000. In this case A will recognize $9.8M of long term capital gain and will pay $1.96M tax on them.
So overall tax paid by A on 01/01/2023 is $2.04M
As you can see, A saved almost $1 million in taxes, by making the code section 83(b) election. A did not even have to wait till 2023 and risk the market fluctuation and could sell the options on 2022 and still enjoy the lower tax rates of long term capital gain.
For more detail about 83(b) elections and other ways where you can save taxes, please contact Quintessential Tax Services.
Section 83(b) election must be made within 30 days from the date you receive stock option subject to vesting.
If you do not make the election, there is no tax consequences on the date of receiving/acquiring the stock option. Once the option is vested, you are required to report its Fair Market Value over your basis as your ordinary income and pay the tax on it. If you decide to hold on to your stock, it will be treated as a Capital Asset once it is vested. If you hold your capital asset for at least one year, upon the sale of your capital asset you will be paying tax with the preferential tax rate (0, 15, and 20%). So you will pay ordinary income tax once the stocks are vested, and capital gain tax once you sale your stocks.
Now, if you make the 83(b) election within 30 days of receiving the stock option, the downside is that you have to pay the ordinary income tax at the time you receive the stock option. But the reason most entrepreneurs make the 83(b) election is that once you make the election, your stocks are considered capital asset, and there is no tax consequences at the time the stocks are vested. Once you sell your stocks (most probably is well over one year after you made the 83(b) election) you will pay only capital gain tax on it. This how smart start-up founders in Silicon Valley and elsewhere save millions in taxes.
Let’s show this in an example: A is an employee in a start-up and his employer on 01/01/2019 gives him 100,000 stock option, vested in 3 years. At the time of granting this option, since the company is brand new, each stock worth $2. Three years later on 01/01/2022 when the stock option is vested, each stock worth $50. A sells the stocks the earliest that he can enjoy the long term capital gain rates.
Scenario 1: A does not make the 83(b) election. Here is the tax consequences at each date:
01/01/2019: No tax due
01/01/2022: A must pay ordinary income tax on $5,000,000 (assuming the highest tax bracket is 40%, A must pay $2,000,000 in taxes). A’s basis in the stocks is $5M and stock are considered capital asset from now on.
01/01/2023: A sells the stock for the total of $10,000,000. He recognizes $5,000,000 long-term capital gain, and pays LT capital gain tax of (assuming the rate is 20%) $1M
So overall A pays $3M in taxes.
Scenario 2: A makes the 83(b) election:
01/01/2019: A must pay ordinary income tax on $200,000. (Assuming he is still on the highest tax bracket) his tax obligation upon receiving the stock option is $80,000. Stocks are considered capital asset from now on.
01/01/2022: No tax due. However, A can sell the stocks at this point and enjoy the capital gain lower rates, instead of waiting for another year like in Scenario 1.
01/01/2022: A sell the stocks for $5,000,000, recognizes $4.8M and must pay capital gain tax of $960,000. Alternatively, A can hold on the stocks and sells them on 01/01/2023 for $10,000,000. In this case A will recognize $9.8M of long term capital gain and will pay $1.96M tax on them.
So overall tax paid by A on 01/01/2023 is $2.04M
As you can see, A saved almost $1 million in taxes, by making the code section 83(b) election. A did not even have to wait till 2023 and risk the market fluctuation and could sell the options on 2022 and still enjoy the lower tax rates of long term capital gain.
For more detail about 83(b) elections and other ways where you can save taxes, please contact Quintessential Tax Services.
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Email: Info@Qtaxservices.com
Phone: (424) 888-3878
Phone: (424) 888-3878