“Regarding my Equity Compensation, What is The 83(b) Election?”
Before we tackle the question at hand, let’s first review the mechanics of equity compensation: Since the 83(b) election applies to Restricted Stock Awards (RSAs), and to a lesser extent, non-qualified stock options, I will limit this discussion to RSAs.
Typically, when an employee receives equity compensation in the form of an RSA, they do not report compensation income at the time of grant. Instead, compensation income is reported in the year the shares vest, and the amount of compensation reported is the fair market value of the shares on the vesting date. This delayed taxation benefits the employee because they are not required to report income until they own the shares outright when the shares vest. However, there may be some situations in which it makes sense to accelerate the timing of reporting income, and this is where the 83(b) election comes into play.
What Is the 83(b) Election?
An 83(b) election allows the employee to change the timing of reporting compensation income. Instead of delaying income reporting until the shares vest, with an 83(b) election, they can accelerate their income into the year they receive the grant. In this situation, the amount of compensation income reported will be the value of the shares as of the day of the grant. It is important to note that if an employee wishes to make the 83(b) election, they must file the election with the IRS within 30 days after the employee receives the grant.
At this point you may be asking yourself, “Why would anybody in their right mind choose to accelerate income and pay the resulting income tax when they can defer that tax over a few years?” This is a great question, and I would agree that normally it makes sense to delay income tax as much as possible, but there are a few situations when accelerating income can end up with tax savings in the future. And the 83(b) election is one of those situations. Let’s take a look at an example:
In return for her services, Jane receives an RSA for 2,500 shares of stock in her company (a start-up). When Jane receives the grant, the stock is worth $5 per share and 100% of her shares vest in three years. Within that three-year period, Jane’s company is exceptionally profitable, and it goes public. Three years later, when Jane satisfies the vesting requirements, the stock is worth $50 per share.
Without the 83(b) election, Jane will not report any compensation income when she receives the grant; however, three years later, when her shares vest, she will have to report $125,000 (2,500 shares x $50 per share) of compensation and pay the resulting income tax. However, if she filed an 83(b) election within 30 days of receiving her grant, she would have only reported $12,500 (2,500 shares x $5 per share) of compensation in the year she received the grant. Therefore, even though she accelerated her income, she saved a significant amount of tax by choosing the 83(b) election! Therefore, making the 83(b) election makes sense if the amount of income tax that an employee will report when they make the election is small and the potential growth in value of the stock is high. Or even if they expect reasonable growth in the value of the stock and the likelihood of forfeiture is small, an 83(b) election may be the best choice to reduce their future income tax potentially. However, an 83(b) election may not make sense if the employee will pay a significant amount of tax upon making the election with only modest prospects for growth in the value of the stock.
However, employees must be aware of some of the risks associated with the 83(b) election. For example, if the stock does not increase in value after the 83(b) election is made, the employee would have accelerated income without receiving any tax benefit. Or if the stock price declines after the election, the employee would have paid more tax than would have been necessary. Worse yet, if the employee is terminated before their vesting date, then they “lose” their shares (forfeiture). In this situation, the election caused the employee to pay tax on income they did not get to keep, with no offsetting tax benefit in the future!
A Significant Strategy For The Future
The 83(b) election can be a great tax planning strategy for employees who receive equity compensation through RSAs. While the tax savings can be significant, it is not a decision that should be made lightly. Be sure to speak with a CFP® professional so that you can get a comprehensive view of how the 83(b) election impacts your personal financial situation.
Contact Zynergy Retirement Planning Today
Equity compensation has become increasingly popular over the years, and if you find yourself in the fortunate position where your company is providing you with equity compensation, then you will want to make sure you know the type of equity you received along with the grant date and vest date. In addition, I would strongly suggest you reach out to our financial planners for a comprehensive look at how we can help achieve your goals and objectives.