You may be wondering what the IRC 83(b) Election is and what the benefits and disadvantages of this election are. We’ll be explaining what it is, why you may want to make the election, and when to do so.
Election and Understanding
Let’s start off by explaining what the IRC 83(b) Election is. This election allows employees or independent contractors the option to pay tax on the excess of the fair market value of restricted property over the cost paid at the time it is granted rather than when it is vested. This election could be beneficial to start up employees who may receive a large part of their compensation in the form of stock options or restricted stock. Keep in mind, the election applies to equity that is subject to vesting.
A benefit of making the election when the restricted property is granted, as opposed to when it vests, is paying tax on a low valuation, assuming the value increases over time. If the amount of income to report from having made the election is minimal, this may be advantageous.
However, a disadvantage is if the election is made and the value decreases consistently; it means the taxpayer will have overpaid tax and will have paid on a higher valuation. If an employee leaves the company prior to the end of the vesting period, they will have paid tax on property they will never receive. When making this election, if the tax liability is significant, an employee should consider the outlook for the stock and, as important, his future with the company..
Once the taxpayer decides this is the route they want to take, they must make the election no later than 30 days after the property is transferred. This includes filing a written statement with the IRS where the taxpayer files their tax return, as well as providing a copy to the employer (also referred to as the service provider). If the taxpayer files their tax return electronically, the address to mail the written statement is based on the location where the taxpayer lives. The statement must be signed by the person making the election and must indicate the election is being made under IRC 83(b). The written statement should also include the following information: (a) name, address, and taxpayer identification number, (b) description of property for which the election is being made, (c) date(s) when the property was transferred and the tax year the election was made, (d) nature of the restriction(s) on property, (e) FMV of property at the time of the transfer, (f) amount of consideration paid for the property, and (g) statement that required copies have been provided to other persons, as required.
Revoking the Election
A question the taxpayer may have is whether or not they are able to revoke the election once made. Unfortunately, the answer is no, unless they have received consent from the IRS. The only time an election would be revoked by the IRS is if it’s a mistake of fact regarding the transaction. The revocation must be requested within 60 days of the date on which the mistake of fact first became known to the person who made the election. A mistake of fact does not include a mistake as to the value (or decline) of the property or a failure to perform an act contemplated at the time of the transfer.
Outcome of Electing 83(b)
Once the election has been made for that specific property, the excess of the fair market value of restricted property over the cost paid will be included in gross income at the time it was granted. Once the restricted property vests, no further compensation will need to be included in gross income. f a taxpayer elects the IRC 83(b) election,The general restricted property rules don’t apply and if appreciation of in the value of the property occurs at a later date, it will not be treated as compensation if the election has already been made. Also, any subsequent dividends are treated as such and not as compensation for services. If the property is later forfeited, any ordinary loss would not be allowed.
If the property is forfeited while it is substantially nonvested, there will be no tax deduction allowed to the taxpayer. Furthermore, the forfeited property will be treated as a sale or exchange; a realized loss would be computed as (a) the excess of the amount paid for the property over (b) the amount realized upon forfeiture.
For capital gain purposes, the holding period for the taxpayer begins when they have made the election. Basically, the taxpayer is treated as owning the property even though they must still satisfy the vesting conditions before possessing a nonforfeitable right to the property. The election converts the appreciation in the property from the grant date through the vesting date from ordinary income into capital gains. When determining the gain or loss from the future sale or exchange of the property, the basis will be the amount paid for the property plus the amount included in gross income because of the election.
Example of IRC 83(b) Election
On October 1st Company B grants an employee 1,000 shares of the company’s stock at a FMV of $7 per share. For the employee to not forfeit the shares, they must stay employed by the company for the next five years after the transfer. If they satisfy the employment restriction, in year five, the value of the stock will become taxable as ordinary income. However, if they make the 83(b) election, the $7,000 value of the stock on October 1st will be taxable to them in the year they were granted as compensation subject to ordinary income tax rates. If the stock appreciates to $10 per share in year five, the employee will recognize a capital gain of $3,000 ($10,000 – $7,000) if the stock is sold in year 5.
Take Away
There is a lot to consider as there are benefits and disadvantages of the election. These are matters that need to be considered and you should discuss this further with your accountant prior to deciding.
If you have any questions regarding this important topic, please contact our office for assistance.
Article Contributed by Beatrice R Calen
