Love money? So do we. In fact, you could say money is what we’re all about. At inDinero, we’ve made it our mission to help businesses like yours save and make money at every opportunity— with smart bookkeeping, accounting, and tax strategies. Rather than keeping everything to ourselves, we’ve decided to share some of our go-to secrets and techniques with our blog readers.
Welcome to inDinero’s Pot of Gold. In this series, you’ll learn quick, actionable tips to protect and build your company’s capital and personal finances. Whether your “pot of gold” is figurative or literal, these tactics will better enable you to maximize your wealth.
Today we’re sharing information about 83(b) tax elections. Learn how filing a relatively simple form now can save you serious cash later on:
What Is an 83(b) Tax Election?
The 83(b) election allows you to pay taxes on the total market value of your equity grant at the beginning of your vesting agreement, as opposed to paying taxes on it annually. In other words, once you own restricted stock in your company, you can hand over a complete tax payment on it right now—at its present value—rather than in increments over time.
Using the 83(b) election means that if your stock explodes in value later on, you won’t have to pay an annual tax on it unless the company gets bought, merges, or goes public. Even then, you won’t be subject to the typical income tax rate, but the (considerably lower) long-term capital gains rate when the stock is eventually sold.
How Does an 83(b) Election Work?
Let’s say your corporation is currently worth $1.00 per share. Today, you were granted 4,000 shares that will vest at a rate of 1,000 shares per year.
Now imagine you think your company will grow over the next several years. By the end of year one, you your stock will increase in value from $1 to $10 per share. It will grow to $20 per share in year two, $40 in year three, and $50 in year four— and then, a few years later, you’ll sell the stock for $100 per share.
But we’re not quite there yet. Let’s back up for a moment.
If you file an 83(b) election now…
- After your initial grant, you’ll pay (what we call ordinary) taxes on your all of your unvested stock (worth $4,000) at today’s income tax rate (let’s assume a 35%), for a one-time tax payment of $1,400. At the end of year one, you’ll pay no additional taxes.
- At the end of year two, you’ll pay no additional taxes.
- At the end of year three, you’ll pay no additional taxes.
- At the end of year four, you’ll pay no additional taxes.
- A few years later, you sell all 4,000 shares for $100 each so you get $400,000 in cash, but you’ll have to pay capital gains taxes. You’ve already paid tax on the 4,000 shares X $1, so $4,000 won’t be taxable. This means you’ll pay tax on $400,000 - $4,000 = $396,000. If your capital gains tax rate is 20%, you’ll pay capital gains tax of $79,200.
- You will have paid $79,200 capital gains tax plus the original $1,400 ordinary tax paid during grant year; the total tax you will have paid is $80,600.
If you choose not to file an 83(b) election…
- You won’t pay any taxes immediately after the initial grant.
- At the end of year one, you’ll owe $3,500 (1,000 shares X $10 X 35%) of ordinary taxes.
- At the end of year two, you’ll owe $7,000 (1,000 shares X $20 X 35%) of ordinary taxes.
- At the end of year three, you’ll owe $14,000 (1,000 shares X $40 X 35%) of ordinary taxes.
- At the end of year four, you’ll owe $17,500 (1,000 shares X $50 X 35%) of ordinary taxes.
- A few years later, you sell all 4,000 shares for $100 each so you get $400,000 in cash, but you’ll have to pay capital gains taxes. You’ve already paid tax on $120,000 of taxable income (in years one through four) so this won’t be taxable. This means you’ll pay tax on $400,000 - $120,000 = $280,000. If your capital gains tax rate is 20%, you’ll pay capital gains tax of $56,000.
- You will have paid $42,000 ordinary tax plus $56,000 of capital gains tax; the total tax you will have paid is $98,000.
Notice the difference? In this scenario, an 83(b) election can save you $17,400 in the long run. Also, most of the taxes will be due after the sale of stock so the cash you receive from the stock sale will come in handy to pay the taxes.
How Much Money Can You Save by Using an 83(b) Election?
It depends. The exact amount of tax savings will vary by situation, but it’s safe to say that shareholders whose companies are new and valued at next to nothing have everything to gain from using the 83(b) election.
Note that in our above example, we’re assuming your income tax rate is 35% (this varies for individuals). Depending on your income bracket, you could gain from using the 83(b) election—or it may be to your advantage to skip it.
What Are the Downsides of an 83(b) Election?
Shareholders in certain situations—such as owners of a brand-new company in which the equity is humbly valued— typically benefit from the use of the 83(b) election more than others.
There is one major risk to the 83(b) tax election. Because your stock could go down in value as opposed to up, you may lose money as well as saving on taxes. This is why founders whose companies have a lower valuation tend to benefit the most from 83(b).
Also, if you leave your company before your restricted stock vests, you'll lose out on the tax money you paid on any unvested shares when you filed the 83(b) election.
Last, note that you only have 30 days after the grant is made to inform the IRS that you will be using the election. To do so, you will need to send the IRS a letter. (To see a sample letter from the IRS detailing all the information you need to include, click here.)
Have questions about 83(b) elections? Want to discuss your options with a professional? We’re here to help. If you’re an inDinero client, email your tax questions to your dedicated account team at [yourcompanyname]@indinero.com. If you haven’t yet signed up for inDinero, we invite you to talk to one of our tax experts.
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