The Teknos team has provided thousands of emerging company valuations.
We are trusted for our experience, our expertise, and our high standards.

What is an §83(b) Election and Do I Need to Make One?

August 4, 2014

A common mistake made by employees who receive a restricted stock award (RSA) or who exercise stock options early is that they fail to file an 83(b) election.  In this article, we explain a bit of this complicated section of the Tax Code, how Section 83 relates to RSAs and stock options, and the consequences of not making an 83(b) election.

Section 83 Explained

Let’s begin with an example.  If an employee who provides services is paid in cash, it’s pretty clear that the payment is considered taxable income upon receipt.  Instead, what if that employee was paid in stock – and that stock cannot be transferred and might even have to be returned if the employee stops working in the future?  In that case, it would be unfair to tax that employee on the value of the stock immediately because it may not remain hers and she certainly won’t be able to sell it to generate the cash necessary to pay the tax. 

When an employee receives stock that is subject to vesting (often referred to as restricted stock), it typically will be taxed as it vests over time.  Section 83 of the Internal Revenue Code states that property (i.e., stock) transferred to an employee is taxable as soon as the employee’s rights in the property are transferable or are “not subject to a substantial risk of forfeiture.”  However, under Section 83(b), a recipient of stock that is subject to a substantial risk of forfeiture can make a one-time election to have her entire interest taxed at the time of the grant (when it may be worth very little) instead of having it taxed incrementally over time as the stock vests (when it may be worth substantially more because the Company increases in value).  The employee must file an 83(b) election within 30 days of receiving the RSA.

What Makes Stock Subject to “Substantial Risk of Forfeiture?”

In general, a substantial risk of forfeiture exists only if rights in property that are transferred are conditioned, directly or indirectly, upon the future performance (or refraining from performance) of substantial services by any person, or upon the occurrence of a condition related to a purpose of the transfer if the possibility of forfeiture is substantial.  In plain English, if stock is subject to a vesting period, then that stock is subject to substantial risk of forfeiture.

Do I Need to Make an 83(b) Election if I Receive Stock Options?

The short answer is no – Section 83(b) does not apply to recipients of stock options.  Most stock options granted to employees at technology companies vest over four years (a one year cliff and then ratably for three years).  In the past, most stock option plans did not allow employees to exercise options before they vested.  However, as competition for talent has increased, many companies have started offering their employees the flexibility to exercise stock options early. 

In this case, an employee who exercises her stock options early (when the fair market value is equal to the exercise price) should file an 83(b) election – before the company appreciates in value.  By filing an 83(b) election, she will have no tax liability until she sells her shares at a gain.  Again, the 83(b) election must be filed within 30 days of the stock option exercise.

In addition, the sooner an employee exercises her stock options, the sooner she can potentially be eligible for the lower long-term capital gains tax rate (which can be applied after owning stock for more than one year). 

What Happens if an 83(b) Election Isn’t Filed?

Under Section 83, if an employee receives an RSA that is subject to vesting and does not file an 83(b) election, that employee will pay income tax on the difference between the price paid for the stock and the stock’s fair market value as it vests, even if the employee does not sell the stock as it vests.  In addition, the holding period for determining whether the income from the sale of the shares qualifies for long-term capital gains treatment will not begin until the shares have vested.

This is a complex tax issue that should be explored by companies and their employees who receive RSAs or stock options.  Consult with the appropriate legal and tax professionals for advice. 

Teknos Associates provides valuations and fairness opinions for technology companies and their venture capital backers. Clients rely on our financial expertise, knowledge of technology markets, and high standards.

Special Note: From time to time, Teknos Associates has been retained by the Internal Revenue Service to perform valuation services.  However, nothing in this communication may be taken to represent the official position or policy of the IRS.  The opinions expressed herein are those only of Teknos Associates.

IRS Circular 230 Disclaimer:  Pursuant to regulations governing the practice of attorneys, certified public accountants, enrolled agents, enrolled actuaries, and appraisers before the Internal Revenue Service, unless otherwise expressly stated, any U.S. federal or state tax advice in this communication (including attachments) is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of (i) avoiding penalties that may be imposed under federal or state law or (ii) promoting, marketing, or recommending to another party any transaction or tax-related matter(s) addressed herein.