How an IRC Section 83(b) Election May Help Minimize Tax

How an IRC Section 83(b) Election May Help Minimize Tax

Section 83(b) Election

How an IRC Section 83(b) Election May Help Minimize Tax: The idea behind making an Internal Revenue Code Section 83 election is that a person elects to pays income tax to the IRS now on units/shares that have been received and not vested — in order to minimize tax liability at a later time.  The downside to an 83(b) election is that not all units granted will necessarily turn into valuable stock — presuming the complete vesting occurs — which means the taxpayer may “overpay” tax to the IRS. In other words, a person may make a Section 83(b) election and then the shares become worthless or never vest — and as a result, the Taxpayer ends up paying more tax than they would have paid (such as if the company goes under before the vesting period occurs). Let’s go through the basics of the Internal Revenue Code Section 83 (b) Election.

26 USC 83(b)

      • “(b) Election to include in gross income in year of transfer

        • (1) In general

          • Any person who performs services in connection with which property is transferred to any person may elect to include in his gross income for the taxable year in which such property is transferred, the excess of—

            • (A) the fair market value of such property at the time of transfer (determined without regard to any restriction other than a restriction which by its terms will never lapse), over

            • (B) the amount (if any) paid for such property.

        •  If such election is made, subsection (a) shall not apply with respect to the transfer of such property, and if such property is subsequently forfeited, no deduction shall be allowed in respect of such forfeiture.

          • (2) Election

            • An election under paragraph (1) with respect to any transfer of property shall be made in such manner as the Secretary prescribes and shall be made not later than 30 days after the date of such transfer. Such election may not be revoked except with the consent of the Secretary.”

Section 83(b) Election Timing is Important

One very important aspect of the Section 83(b) election is that the taxpayer only has 30 days from the date of the transfer to make the election; otherwise, taxpayer loses the ability to make such an election — exceptions, exclusions and limitations to the 30-day rule may apply.

Example of Section83(b) Election

Michelle gets a job with XYZ Corporation. XYZ Corporation wants to motivate Michelle, so upon accepting the offer, they offer Michelle non-vested stock options. It is a relatively new company and the stock options are only worth $0.10 each; Michelle receives 10,000 shares. Michelle’s stock options will not vest for another five years. In other words, she will not have access to the stock for at least five years – the purpose being Michelle has to prove that she is a long-time employee and wants to remain with the company (in addition to certain laws that require a waiting period before vesting).

Elect the IRC 83(b) Tax Liability

This is where Section 83(b) kicks in. If Michelle wants to, she could pay tax now on the value of the unearned stock. In other words, the stock is worth $1,000. Therefore, if Michelle claims the stock as income in her current tax return, she would pay an additional tax on those earnings now.

Why Make a Section 83(b) Election?

The main reason is Michelle hopes that the company increases in value exponentially. Then, the value of Michelle’s shares will also increase. As such, she can offset paying a full ordinary income tax base later on the current FMV at that time by making payments now where the FMV is lower and then selling down the line and achieving capital gains rates instead.

Example of the Section 83(b) Election Analysis

  • 83(b) Election?

        • The stock is currently worth $0.10.

        • Michelle pays income tax on it now and she owns 10,000 shares at an overall base of $1000 (presume they are all in the same lot).

        • In five years from now, the stock is worth $5.00 a share.

  • No 83(b) Election?

        • If there is no 83(b) election, Michelle waits the five years to gross-up the income and pay the tax, BUT Michelle would have to pay income tax on $50,000 of income.

Why? Because the units have become vested stock — which is a form of income. It is not yet capital gain since it is being earned from the work performed by Michelle and not from the sale of the stock.

Later, It Becomes Capital Gain

Continuing from the above example, if Michelle paid income tax at the time she received the shares ($0.10 per share) as opposed to when she had the shares vest ($5.00 a share), the overall tax liability will be much different, and in this case, much more beneficial to Michelle in the future.

In the sixth year, Michelle sells the stock for $5.00 per share.

Here’s how the difference in the analysis works:

*For this analysis, presume Michelle has had a net-effective tax rate of 30% at all times and a long-term capital gain rate of 15%.

$0.10 Per Share with a Section 83(b) Election

    • Michelle owns 10,000 shares with the base of $1,000. In the sixth year she sells the stock for $5. As a result, Michelle will pay long-term capital gain on the additional money received.

      • $0.10 per share of ordinary income per share when received (30% Tax)

      • $3.90 per share of long-term capital gain when they are sold (15% Tax)

        • Result: $50,000 in Proceeds – $1,000 in basis = $49,000 in Long-Term Capital Gain at 15%

          • Total Tax Due = $49,000 * 15% = $7,350

$5 Per Share & No Section 83(b) Election

Michelle waited to pay the income tax until the stock vested. Michelle is highly risk-averse and the idea of paying any additional tax on income that she may not receive, is not something she could pull the trigger on. For example, if Michelle paid the income tax on the initial $0.10 a share but the company went under before it becomes profitable, then Michelle would have paid tax on income that she will never see.

Luckily, the company does well but Michelle’s tax base is much different. 

      • $5 per share of ordinary income (30% Tax)

      • $5 per share of long-term capital gain when they are sold (15%)

        • Result: $50,000 in income, taxed at 30% 

          • Total Tax Due = $50,000 * 30% = $15,000

*When she sells the stock, Michelle’s basis will be $50,000 and capital gains would be less (unless the current administration changes the CG rules for higher income earners, which could impact Michelle at the time of sale.

In this particular scenario, Michelle will end up paying significantly more tax, since she waited for the stock to vest, which will make the majority of Michelle’s earnings taxed as ordinary income instead of capital gains.

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