There are many ways to reduce your tax load and build wealth faster, but most people don’t know about the 83(b) election.
This simple letter allows you to reduce your taxes and build wealth much faster, saving you a lot of money in the long run.
In this quick read, I’ll walk you through some of the more common questions I get when handling this for clients of DJH Capital Management.
I hope this will help you save on taxes so that you can reach financial goals sooner!
What is an 83(b) election?
Per the IRS, Section 83(b) permits the service provider to elect to include in gross income, as compensation for services, the fair market value of substantially nonvested property at the time of transfer.
In layman’s terms, it allows a taxpayer to accelerate or bring forward a future tax liability and pay it now essentially capping the amount of taxes paid on appreciation of that award.
An 83(b) election allows you to recognize the gain on a restricted stock award or share of stock before it’s vested, saving you money in taxes and building wealth faster.
The election must include several pieces of information, like the following:
- taxpayer’s information;
- property for which election is being made;
- date of transfer and taxable year for which election is being made;
- any restrictions to which the property is subject;
- fair market value; and
- amount paid for property;
When should you file one?
Whenever a significant amount of your compensation is tied to “incentive” pay like stock options and restricted stock awards you may want to consider this strategy.
Keep in mind, however, that the election must be made within 30 days of your grant date so the clock of decision begins ticking from the date of your award.
What are the drawbacks?
If the award doesn’t appreciate then you’re left with the fact you’ve just paid taxes on something early for no reason. That could suck and is a legitimate risk.
Also, you’ll want to make sure that any separation of service events like death, disability or termination won’t negatively impact you if you choose this election.
The 83(b) election is a one-time opportunity and you don’t get to take it back, so you’ll want to consult with your financial advisor and a tax professional to game out a few tax scenarios on their fancy software for you.
Let’s look at an example…
The share of stock that you’re granted and don’t sell is called a distribution with respect to your employer’s company (even if it was originally an award to you).
The IRS will classify any such distributions as ordinary income, which means they’ll be taxed at ordinary income rates.
Remember, by making an 83(b) election you are choosing to be taxed on something that is not currently taxable but may be in the future.
I recently had a client that was hired by a private company and they awarded him 7,000 stock options. The company was just recently valued at $20/share.
At this point, there are a couple of choices to make..
(1) we could wait and let them vest; or
(2) file 83(b)
We’re choosing choice #2, because my client has the cash to early exercise the options by filing the election and pay the taxes on the fair market value of his award now (i.e 7,000 x $20/share).
This will be taxed at AMT rates (another discussion for another time) and cap the amount of ordinary income tax he pays (on this award) at 7,000 x $20/share. When he chooses to sell the shares of those exercised options he’ll only be taxed at capital gain rates on the difference between the sell price and $20/share.
But what if we went with choice #1…
As many individuals do (intentionally or not), they fail to make a timely filing of the 83(b) election is similar scenarios and the following occurs.
Let’s say that the fair market value of the company goes up. In the case of my client, the company eventually goes public and the new price per share is now $100.
Now he’ll be liable for an extra $80 per share of ordinary income taxes –another $560,000 income in the highest bracket!
Therefore, by choosing to file the 83b election and pay taxes upfront you are saving on the potential appreciation of your award.
Some final tips to remember before filing your 83b election…
– You must file the form within 30 days of receiving restricted stock or stock options.
– Your company may require a signed affidavit stating that you understand the implications of such a filing.
– You may want to consult a professional before filing the election. This is especially true if you have never filed an 83b election before. Nuance is key when it comes to filings and you want to do it correctly!
Leave your questions/comments below this post and I’ll do my best to try and answer them for you.