The IRS 83(b): How to File, Why It Matters and 3 Things About Elections for Restricted Stock
Many investors in startups are not familiar with the IRS form 83(b). It is important to understand the tax code section 83(b), how to fill out the 83 b election form the IRS requires, and how to submit the 83 b election where to file it properly.
The IRS and 83b affects the restricted stock 83b covers. Small business investors who desire to learn how to invest money benefit greatly from having knowledge about the IRS 83 b provisions. There is a strategic decision about when to use the IRS rule 83b and the advantages of doing so for those that invest in startups.
IRS form 83(b) - Definition and Why it Matters
First, let’s examine the actual IRS rules for tax code section 83(b) to understand what the tax code says about it. Fidelity gives specific instructions on how to fill out the 83 b election form IRS requires.
The IRS publishes the actual details of how the 83 b election works, which we summarize here:
A person paid for services by restricted stock instead of cash, has the option of filing a form with the IRS to note their election (choice) to have the difference between the fair market value of the stock and the value of the services taxed as income in the year of receiving the restricted stock.
This election must be filed in the first 30 days after receiving the restricted stock.
This is a strategy to reduce future taxes.
Why would anyone want to pay taxes on the excess value of a non-cash receipt of restricted stock?
It seems counter intuitive, yet in certain circumstances, filing an election under IRS rules 83(b) is a great idea.
CooleyGo gives a terrific explanation of how to use the strategy of filing an election under IRS rules 83(b) for future benefit. The first thing noted is that the election needs filing quickly, within the first 30 days after receiving the restricted stock allocation. This process of filing an election under IRS rules 83(b) only works for stock that vests (is granted) over time. If stock is given without waiting for a time period to be vested, it is valued on the date it is given.
Capital Gains Tax Versus Ordinary Income Tax
The capital gains tax rate is less than the ordinary income tax rate. By making the election early under IRS rules 83 b the value of the stock is the lowest possible (assuming that the company succeeds and the stock value goes up).
When a person declares to the IRS under IRS rules 83 b that the stock has a current value of a specific amount, the IRS uses that amount to calculate the ordinary income tax portion.
In the beginning of many startups, the value of the stock is very low. By declaring the value and reporting to the IRS using the IRS rules 83 b form, it sets the stock value at this low amount. Yes, taxes must be paid on this non-cash transaction according to the person’s tax liabilities. However, everything that happens afterwards is capital gains. The tax on capital gains is a lower rate and only paid upon selling the stock.
Start the Long-term Capital Gains Clock Early
Here is an example. Imagine a person gets restricted stock that vests over a period of five years. At the time of getting this grant of restricted stock, the shares are valued at $1 each. This valuation comes from the early venture capital investment in the company. Imagine the grant is for 10,000 shares.
At the time of the grant, the value is $10,000 in stock that the person will receive over the next five years. This person within 30 days of receiving the stock has the option to make an election to treat this value as ordinary income. Is this a good idea? It depends on the success of the company.
Treating this as ordinary income creates a tax event for a non-cash transaction. The election under IRS rules 83(b) means paying taxes at whatever rate ordinary income is taxed. However, any gains thereafter have the much lower rate of capital gains tax of 20%. If this stock becomes worth $5, $10, $50, or more per share in future years, the tax savings are immense.
Conclusion about the IRS' 83(b) Election and What You Need to Know.
The election of treating any receipt of restricted stock as ordinary income under IRS rules 83(b) is a bet on the future value of that stock. This election requires paying taxes in the current year. This strategy is about ultimately reducing the tax burden when a stock creates great value in the future.