If your employer grants you stock as part of your compensation package, electing section 83(b) can change how the stock is taxed. Normally you get taxed on employer granted stock based on its value when it vests. A section 83(b) election allows you to be taxed based on the stock’s value when it’s granted, an earlier date.
If the stock grows in value between the grant date and vesting date, this will save you some taxes.
While this is normally done only with restricted stock, there are circumstances when you can elect 83(b) in relation to employer stock options. You normally only see this done with stock options granted by private, pre-IPO companies however.
Let’s take a look how this works.
The 83(b) Election - Quick Review
First, let’s review how 83(b) works by way of example. Let’s say you are granted stock by your employer. It’s worth $15,000 at that time, but you can’t sell it until it’s vested in one year’s time. Tax-wise, nothing happens at this point.
In one year the stock vests and it’s worth $25,000. The stock is officially yours. You can sell it and if you leave the company you can take it with you. Since it has vested you have to pay tax on the $25,000. If you are in the 24% tax bracket you have to pay $6,000 (24% * $25,000) in federal income tax. PLUS, you have to pay social security tax and medicare tax and any state income tax that may be due on the $25,000.
Keep in mind you haven’t received any extra cash. Just the stock. So to pay the tax you have some choices: (i) you can use cash from other sources, (ii) pay more witholding to cover the taxes, (iii) or sell some of the stock.
If you elect 83(b) within 30 days from the grant date you pay tax on the stock’s value on the grant date. Here that’s $3,600 (24% * $15,000) instead of $6,000. You’ve saved $2,400 (plus payroll taxes and state taxes).
Can you elect 83(b) for stock options?
Normally you can not elect section 83(b) when you receive an employer granted stock option. The IRS is pretty clear about this. Section 83(b) only applies when there has been a transfer of property, like a transfer of stock from an employer to employee. The tax regulations (see: Section 1.83-3(a)(2)) are clear that a grant of an option to an employee isn’t a transfer of property. And that makes sense. You can always let the option expire and the option vanishes!
But, there is a loophole. If you have the ability to exercise an option early and the stock you receive isn’t vested, you may be able to elect section 83(b) on the non-vested stock.
83(b) for Early Exercise Options
If you are granted an employer stock option check the grant agreement. If it allows you to exercise it early and the stock you receive isn’t vested when received, you may be able to elect section 83(b) against the stock.
The ability to exercise options early is often provided by pre-IPO start ups. The idea is that you can exercise the option now before the stock “pops” in value. That way you pay tax when the stock is cheaper instead of waiting and paying tax after the IPO when the stock value might be higher.
The consequences of electing 83(b) early are different when the option is an Incentive Stock Option (ISO) vs. a Non-Qualifed Stock Option (NQSO).
Let’s compare the situations.
Early exercise of an NQSO
Let’s say you’re working at a start-up and they grant you a nonqualified option to buy 1,000 shares at a price of $0.50 per share. The stock is worth $1 at that time. When the option vests in one year, the company has grown and the stock is worth $10 per share.
If you exercised the option when it vests, you’d have to report $9,500 ($10,000 – $500) in taxable compensation income (including payroll and state taxes).
Instead, let’s assume the grant agreement lets you exercise the option early. You exercise the option on the grant date (or soon after) and receive stock that isn’t vested yet. If you don’t elect 83(b) you would pay tax on the stock’s value when it vests. Here you’d pay tax on $10 per share or $10,000 less the $500 you paid to exercise.
If you elect 83(b) you pay tax on the fair market value of the stock when you received it, less the amount you paid to exercise the option. So, you’d report $500 ($1,000 – $500) in compensation income. The 83(b) election saved you $9,000 (not including payroll tax and state income tax).
If you elected 83(b) and sold the stock later for $20 a share, the growth from $1 at grant date to $20 would be capital gains!
Early Exercise of an ISO
If you received an Incentive Stock Option (ISO) instead, exercising it early and electing 83(b) reduces your potential Alternative Minimum Tax liability. This can be a good thing, but there are risks. (If you want a summary on how Incentive Stock Options (ISOs) work, you can read one here.)
Let’s keep with the example from above. You receive an option to buy 1,000 shares at $0.50 per share. Except this time the options are ISO’s, not NQSO’s.
Again, you exercise the options early, right after they’re granted. You receive the stock, but it won’t be vested for another year.
Since these are ISO’s you don’t pay any regular income tax on the grant date OR the exercise date. But, recall, there’s a holding period for ISOs. You need to hold the stock for more than one year after exercise and two years from the grant date. Since you held the stock beyond the year in which you exercised them you triggered the Alternative Minimum Tax (AMT).
To calculate your AMT take your regular taxable income and add to it the difference between the value of the stock when they vest less the price you paid for the options. That’s what you’ll end up paying in tax for the year.
Here’s where Section 83(b) comes into play. If you elect 83(b) you can instead pay AMT on the value of the stock when it’s received, instead of when it’s vested.
In the above example, the stock is worth $1 when it’s granted and $10 when its vested. If you don’t elect 83(b) you end up paying $9,500 ($10,000 – $500) in AMT. If you do elect 83(b) you pay only $500 ($1,000 – $500).
Some Risks for electing 83(b) with ISO's
You should keep some risks in mind with this strategy.
One, if you’ve exercised the option early but the stock’s value has already increased by that point, you may still owe substantial AMT tax. In this case, you might not elect 83(b) and wait for the stock to vest. This way your AMT is based on the vesting date and maybe by then the stock price has dropped or you have left the company. Either way it saved you money.
If you elect 83(b) and the market is falling, you may end up paying tax on a stock that will be worth much less when it vests. In that case, it may be better to wait.
Also, recall with an ISO you have to hold the stock for more than one year after the exercise date and two years from the grant date. That means you might have to hold onto the stock for longer than you might otherwise.
Conclusion
While you can’t elect section 83(b) on employer stock options, if the stock you receive from an option isn’t vested (because you exercised the option early, say), you can elect 83(b) to accelerate tax on the unvested stock. For a NQSO, this would mean reporting taxable compensation income earlier, instead of waiting until the vesting date. For ISO, this would mean potentially reducing the amount of AMT you owe.
Careful planning is important here. As we’ve seen, the stock market doesn’t always go up. A falling market might change whether you elect section 83(b) or not.