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A Visual of the 83(b) election
Your employer has probably made it painstakingly aware that you’re paid in several different ways: salary, benefits, and if we’re fortunate enough – ownership through company shares.
The focus of this article is not to delve into the numerous forms of stock options and compensation – but to touch on a technique that can potentially help save you some dollars.
You’ve probably heard of the mysterious 83b election. This article aims to break down a somewhat complex topic into a visual, easy to understand format.
As always, consult your tax and legal professional for any specific questions you may have. This is not meant to be interpreted as tax or legal advice.
An OVERLY simplified background on taxes
Before we dive into the topic at hand, let’s quickly revisit what taxes look like.
Taxes will typically fall into one of two buckets:
Ordinary Income Tax
Ordinary income tax typically applies to our salary, IRA withdrawals, bond interest, rental income, sale of short term investments, and some of our equity compensation.
As of 2023, the range of tax brackets that apply to ordinary income range from 10%-37%. In the US, we have a “progressive tax system” that applies to our taxable income. Essentially, we pay different amounts of taxes on different parts of our income – it’s not a flat tax. It can best be visualized as a step ladder, whereby we pay different amounts of tax on different “rungs” of the ladder.
See figure below (2023 rates for single filers 1 )
As a quick and simple example, if your income was $12,000 for the year, you’d pay tax of 10% on the first $11,000 and 12% on the next $1,000. Rinse and repeat.
Long Term Capital Gains Tax
Long Term Capital Gains tax will typically apply to assets we’ve sold after one year of ownership.
It can also apply to qualified dividends. Thankfully, this stepladder is a lot shorter (and simpler).
See figure below (2023 rates for single filers 2 )
To provide another quick and simple example, if our gross income for the year was $50,000, any sale of stock we sell at a profit (provided we held it for more than one year) would be taxed at 15% – much lower than what your marginal bracket would be for ordinary income.
It should be noted that for high income earners, there is another “penalty” for you to be aware of: the NIIT (net investment income tax). Technically, there is a second, AMT (alternative minimum tax), but we’ll leave that discussion for another time.
Net Investment Income Tax (NIIT)
Net investment income 3 tax applies to individuals who receive investment income AND earn regular income above certain levels.
Per the IRS website, investment income can include the usual suspects: bond interest, dividends, capital gains, rental income, and more.
Long story short, if your income subjects you to NIIT and you sell a stock at a long term gain, you may owe an additional tax liability 3.8% on top of your gains bracket.
For example, if your income for the year subjects you to the 20% long term capital gains tax bracket and you are subject to NIIT, your total “tax” for the sale of that investments comes out to 23.8%.
To keep the math easy, this article will assume that you are not subject to NIIT.
Another thing to keep in mind as you read through this article is that we never completely hide from Aunt IRS. However, what we CAN do is to try and maintain some level of control over how much and when we pay taxes.
The objective in making an 83(b) election is to exercise this control and potentially reduce our taxable income – specifically as it relates to our share ownership. If we do this over several years and several grant dates, we slowly start putting the control back in our favor. So, how do we do that?
What is the 83(b) election?
In a nutshell, by making an 83(b) election 4 you volunteer to pay some taxes now in hopes that you pay less later.
It’s a similar thought process to making Roth conversions: you think your future bracket may be higher (due to required distributions, multiple sources of income, and/or changes in tax laws) in the future so you volunteer to pay some tax at your current (and potentially lower) bracket.
Except the decision in making the election is not just about brackets, it’s also about the future fair market value of the shares you own. In essence, you’re betting that the value of the common stock will be worth more in the future (where we’d like to pay long term capital gains taxes) than it is today (where we’d volunteer to pay ordinary income rates).
It can be helpful to think of it as a timeline where the are two “trigger events” for taxation.
The first trigger event recognizes the stock value as ordinary income.
The second trigger event occurs when the stock is sold. Provided you’ve held it more than a year, this should fall under long term capital gains rates.
To provide a better visual, assuming you do not make the election, the trigger event for tax purposes resides further out in the timeline. See below:
On the flip side, if you do make an 83(b) election, the tax implications reside much earlier in the timeline. See below:
What is the benefit of an 83(b) election?
In a perfect world, our fiscal benefits increase in direct proportion to the efforts we contribute to the company we work for.
Not just in the form of raises, but hopefully the company’s stock price goes up and as a result our overall net worth goes up as well.
The benefit of the election is that we pay early on – before the potential growth spike happens.
To put some math behind it, let’s assume the following scenario:
Grant Date: 1/1/2023
Number of shares: 1
Fair Market Value on grant date: $100
Stock Vests: 7/1/2023
Fair Market Value on upon vesting: $1,000
Stock Sold: 9/1/2024
Fair Market Value upon sale of stock: $2,000
As you can see above, because we made the election within 30 days of the notice, we were able to pay ordinary income taxes when the value of the shares were lower. We then get to bypass any tax trigger when they vest, and only recognize the second taxable event upon the sale of the stock (hopefully a year or more later).
By the same token, if we do not make the election, we get taxed at ordinary income rates on the shares’ vesting date, (and when they’re worth more), and again when they are sold.
If the stock price goes up, we potentially save money by making the election.
What is the downside of an 83(b) election?
Flip the above scenario on its head and it’s pretty easy to see the drawback in making an 83(b) election. Nothing is perfect, and if the price of our stock drops, we may be paying more than if we had not made the election to begin with. Let’s assume the following scenario:
Grant Date: 1/1/2023
Number of shares: 1
Fair Market Value on grant date: $100
Stock Vests: 7/1/2023
Fair Market Value on upon vesting: $50
Stock Sold: 9/1/2024
Fair Market Value upon sale of stock: $10
Using the above fact pattern, you can see that volunteering to pay taxes (when the value of the shares was higher) through the election costs you more money than not filing the election (when the value of the shares was lower). Another caveat is that there was some value to the shares when they were sold.
While it does not happen to every company out there, it can be possible for shares of a company to become worthless (it can happen to large companies as well as startup and pre-IPO companies). It’s a risk you take and an important reminder of why it’s not a “one-size-fits-all” rubric.
How do you file an 83(b) election form?
There are some ground rules that we need to understand and abide by as part of filing an 83(b) election 5.
It’s time sensitive. You have 30 days to make the election, regardless of when you were notified.
Mail (or you can provide an electronically signed form until 10/31/2023) the election form to your local IRS office where you would normally send payments/returns.
In addition to Aunt IRS, you’ll want to notify your employer of the election as well. Provide them a copy.
Confer with your tax preparer if you should include a copy with your state return, if applicable.
Keep a copy for your own records.
Tying it all together
While there can be obvious benefits in making the election, there are also situations where it might not pay off. Understanding both your financial situation as well as that of the company you work for are key.
If you’re finances can’t handle the tax payment and/or the outlook of the company isn’t so rosy, then it might be best to hold off.
Conversely, if finances aren’t an issue and your feel quite bullish on the company’s growth prospects, all signs might point to yes. The good news is you’re probably in the best position to make an informed decision. Need help? Let us know.
Sources:
1. https://www.irs.gov/newsroom/irs-provides-tax-inflation-adjustments-for-tax-year-2023
2. https://www.forbes.com/advisor/taxes/capital-gains-tax/
3. https://www.irs.gov/newsroom/questions-and-answers-on-the-net-investment-income-tax
4. https://www.irs.gov/businesses/corporations/equity-stock-based-compensation-audit-techniques-guide
5. https://www.sec.gov/Archives/edgar/data/1430602/000119312509122148/dex99a1viii.htm
