At its most basic level, a Section 83(b) election is an election to be taxed on property received in connection with the performance of services even though the taxpayer may not get to keep or may have to forfeit that property. For example, suppose you receive nontransferable shares of stock from your employer but they do not vest until you have provided 1 year of service. You could, if you wanted, wait to be taxed on those shares until 1 year passes. The problem with this approach? The shares might increase in value substantially over the course of that year and when the shares vest you may not be able to afford the taxes that become due on vesting. An alternative is available under Section 83(b) of the Internal Revenue Code. Under Section 83(b), even though you might not get the keep the property you received, or may have to forfeit it, you can elect to be taxed on your receipt of the property at the time you receive it, instead of waiting until it vests.
Under Section 83 of the Internal Revenue Code:
- a taxpayer who receives property in connection with the performance of services must generally recognize as ordinary income the difference between the value of the property and the amount paid in exchange therefor at the first time the property is either transferable or not subject to a substantial risk of forfeiture.
- Section 83 allows a taxpayer who receives property in connection with the performance of services that is subject to such restrictions (e.g., nonvested property) to elect to recognize this income at the time of transfer.There are a couple of benefits of a Section 83(b) election:
- (i) the taxpayer avoids having ordinary income on vesting; and
- (ii) the taxpayer starts the capital gains holding period.
For example, suppose a startup company founder is issued founders’ stock that is subject to a company repurchase at the stock’s cost, but the repurchase right lapses over a service based lapsing period. This founder has received stock, but because the stock is subject to a substantial risk of forfeiture (the at-cost repurchase right lapsing over the service based vesting period), the founder does not have to pay tax on his receipt of the stock until it vests. However, the founder may prefer to make a Section 83(b) election to pay tax on the value of the stock today because its value is lower than it is expected to be when it vests–or because the founder paid full value for it today, so the Section 83(b) election costs him no additional tax today. The making of the Section 83(b) election also starts the founder’s capital gains holding period.
Frequently Misunderstood Points
If a founder receives shares that are fully vested–that is, not subject to an at-cost repurchase right that is lapsing over a service based vesting period–no Section 83(b) election is required.
It is a common misconception, but a Section 83(b) election generally cannot be made with respect to the receipt of a private company stock option. You must exercise the option first and acquire the stock before you can make a Section 83(b) election, and you would only make a Section 83(b) election in that instance if you exercised the option and acquired unvested stock (if the stock acquired on exercise of the stock option was vested, there would be no reason to make a Section 83(b) election).
Another common misconception is that Section 83 does not apply to restricted stock that is purchased at fair market value. This is not true. Section 83 applies even to stock that has been purchased at fair market value, if the stock is subject to a substantial risk of forfeiture and received in connection with the performance of services. See this case, Alves v. Commissioner.
An 83(b) election has to be filed with the IRS within 30 days of receipt of the property, a copy has to be filed with the tax return of the person making the election, and a copy must be provided to the company.
Additional information about making the election can be found Code of Federal Regulations.