Many people associate taxes with only one date: April 15. In reality, though, tax planning should be a year-round part of your financial life.
For instance, tax planning can and should be incorporated into investment decisions, charitable giving and business planning. And in some cases, taxpayers face decisions far before April that can create big impacts when they eventually file their returns. For instance, those receiving property such as stock distributions from employers may face the question of whether to make an 83(b) election. But before taking advantage of this tax-planning technique, they have to know what it is and that it’s available to them — and they need to act on that information promptly.
To understand what an 83(b) election is, let’s start with a review of a related portion of the tax code. Internal Revenue Code Section 83(a) governs taxation of property transferred to an employee in exchange for services. For instance, if you work at a startup and receive company stock as part of your compensation, Section 83(a) says that the income represented by the fair market value of that stock does not have to be included in your taxable income until you know you will keep it (for instance, when it vests) or the stock becomes transferable (that is, you could sell it or give it away). The rule says that property is taxed as of the first time it is transferable or not subject to a substantial risk of forfeiture, whichever comes first.
But what if you wanted to accelerate the process for tax purposes? Section 83(b) allows you to do so without waiting for the triggering provisions in the preceding rule. If the person who receives the property elects to include its fair market value in his or her gross income in the tax year in which the transfer takes place, the taxable amount will be the stock’s fair market value at the time of transfer, less what was paid for the property, if anything. Making an 83(b) election sidesteps the rule in Section 83(a) for the property in question. However, there is risk involved. If you lose or forfeit the property, since it was subject to restriction at the time you paid tax, you can’t take a deduction for the amount you already included in income from the election or for any taxes you paid as a result. If you later sell the property, you also still have to pay capital gains tax on any appreciation after the time of transfer.
In exchange for these risks, an 83(b) election offers some clear benefits. If the stock becomes more valuable between the time of transfer and the time it vests, you successfully locked in ordinary income tax at the lesser amount. Additionally, making the election starts the clock on the capital gains holding period, meaning if you sold the stock more than one year after making the election, you would pay capital gains tax at the long-term rates. Of course, if your stock declines in value, you have paid more than you might have if you had waited. And since an 83(b) election is irrevocable, there is no way to undo the decision, unless the commissioner of the Internal Revenue Service grants a special exemption.
There are a few other reasons you might make an 83(b) election, despite the risks. For instance, if the property’s value is nominal at the time you receive it, the tax might be so insignificant that it makes sense to pay it right away in the hopes of avoiding a higher tax bill in the future. Taking this a step further, if you expect the property’s value to increase substantially before your interest in it vests, you may worry you won’t be able to afford the tax when it eventually comes due. For taxpayers who pay the fair market value of the property in the first place, electing to be taxed on its fair market value over what was paid for it would mean no tax is owed. Some taxpayers may wish to make the 83(b) election simply to start the capital gains holding period.
It is important to keep in mind that, while making an 83(b) election comes with risks in the form of potentially overpaying taxes or paying tax on property you could forfeit, failing to make such an election brings risks of its own, as noted above. If your property appreciates substantially between the time you receive it and the time it vests, you may have substantial income tax liability, even if you don’t sell the property.
Here is how it might play out. Abby and Jennifer are hired the same day for identical roles at a company. After their first year, each is granted a restricted stock award. The grant has a purchase price of $1 per share and is subject to a four-year vesting period. They each decide to accept the grant, and Abby promptly files an 83(b) election, but Jennifer does not.
At the end of the first year, the company’s stock has appreciated to $100 per share. Jennifer recognizes $99 per share as income (the value less the purchase price) on the portion that vests, even though she doesn’t sell her stock. Abby doesn’t recognize any additional income, since she made her election a year prior. Over the next few years, as the stock continues to vest, Jennifer realizes income equal to the difference between the fair market value of the stock at time of vesting and the $1-per-share purchase price. Abby, having accelerated the income recognition, does not. Assuming both partners stay until they are fully vested, Abby comes out ahead because of her lower income tax liability. Abby also has access to long-term capital gains rates sooner, since she started the clock on her holding period early.
Of course, an 83(b) election is not always appropriate. Consider a newer employee, Frank, who joins the company a year later when the stock is already at $100 per share. Frank will need to consider carefully whether he expects the stock’s value to rise, fall or stay the same over his vesting period. Or, returning to Abby, if she needs to leave the company in 10 months and before any of the stock has vested, she will have paid tax on stock she ultimately forfeited. When making the election, it is always important to realistically weigh the probabilities of future outcomes.
If you have private company stock options, rather than receiving stock outright, you won’t need to worry about 83(b) elections unless you use the stock options to purchase unvested stock. And if you receive stock without vesting restrictions, you won’t need to worry about an election at all.
How To Make An 83(b) Election
A taxpayer who wishes to make an 83(b) election should do so promptly after receiving the property in question, within 30 days of receipt. The taxpayer will, of course, need to notify the IRS, and must also notify the employer (or whoever granted the property).
While the IRS has created hundreds of tax forms for all sorts of situations, oddly, no official form exists for those who wish to make 83(b) elections. Instead, taxpayers must send a letter to the IRS office where they file their income tax returns. The IRS has provided some sample language for such a letter in Revenue Procedure 2012-29. While this language is not required, it is an example that would satisfy the agency’s regulations. Information that the IRS suggests taxpayers should provide when making elections includes:
- A statement making the election
In the sample language, this statement reads: “The undersigned taxpayer hereby elects, pursuant to §83(b) of the Internal Revenue Code of 1986, as amended, to include in gross income as compensation for services the excess (if any) of the fair market value of the shares described below over the amount paid for those shares.”
- The taxpayer’s full legal name, address, Social Security number and tax year associated with the election
- A description of the property (for instance, “1,000 shares of Jennifer and Abby’s Company Inc.”)
- The date on which the property was received
- The restriction that will cause forfeiture if not met or the restriction that will lapse when vesting requirements are satisfied
- The fair market value of the property, without the restriction, at the time the taxpayer received it
- Any money paid for the property
- The amount to include in gross income (that is, the fair market value less anything paid)
- A statement regarding filing the election
In the sample language, this statement reads: “The undersigned taxpayer will file this election with the Internal Revenue Service office with which the taxpayer files his or her annual income tax return not later than 30 days after the date of the transfer of the property. A copy of the election also will be furnished to the person for whom the services were performed. Additionally, the undersigned will include a copy of the election with his or her income tax return for the taxable year in which the property is transferred. The undersigned is the person performing the services in connection with which the property was transferred.”
As the closing statement implies, a copy of the letter should go to whoever granted the property — usually an employer — and a second copy should be included with the income tax return for the year. (And, of course, a copy should be kept for personal files.) As with anything mailed to the IRS, a return receipt will prove the letter was filed with the agency on time.
Taking the time to understand 83(b) elections and making a timely choice about them can save you quite a bit of tax liability in the long run. It is just one of the many ways that remaining tax-minded throughout the year can make for a happier April.