Today we are going to tackle the topic of the good old 83b election. Warning ahead of time – we are going to talk about taxes. I swear I will do my best to keep it not so boring.
I’m thinking right now about how deep I want to go with 83b elections. The reason is because 83b elections apply to Restricted Stock Awards and sometimes to Nonqualified Stock Options. You know what? Let’s cover the basics of what an 83b election is and then I will decide how deep to go.
The short version of what is an 83b election is rather simple. It is basically you telling the IRS you want to pay taxes now on stock before it is vested. Simple right. But what does that mean? For my example I am going to use Restricted Stock Awards, also known as Restricted Stock. 83b elections do NOT apply to Restricted Stock Units. And, they may or may not apply to Nonqualified Stock Options.
Back on topic, when you are granted Restricted Stock you get the stock, sort of. Restricted Stock goes into an escrow account so it kinda belongs to you. You get dividends and have shareholder rights, but it is not completely yours until you meet the vesting requirements. These are often time requirements.
However, because Restricted Stock is in escrow you have the option to do what is called the 83b election. It is an election because the choice is yours. And, the choice needs to be made quickly. You have 30 days from when the Restricted Stock hits escrow to fill out the necessary paperwork and file it with the IRS. The paperwork says you are treating the Restricted Stock as being fully vested upon it hitting escrow. This means you are paying tax on it now and not later when it officially vests.
The tax issue is pretty simple too. Once the 83b election occurs you are recognizing compensation income for the fair market value of the Restricted Stock, minus anything you may have paid toward it. I told you it was simple.
Before I forget, it is certainly fine not to go the 83b election route. This simply means you are delaying the tax bill until the time the Restricted Stock vests normally. The same tax rules apply as far as compensation income of fair market value minus anything you paid for it.
So, the question then becomes – why would someone go the 83b election route? Good question. I can’t and won’t even try and share every reason why someone would go the 83b election route, but I will highlight a few of the more common reasons.
First, you know your income will be changing in the near future. For example, you happen to work for a company that has a very generous Equity Compensation plan. Maybe you haven’t been there that long or you are not that high on the old corporate ladder. However, you know you will be moving up the ladder and will receive higher compensation and even more equity compensation awards down the road. More money more problems, right. Well, with an increase in income your tax rates and tax bills will most likely be going up too. And to add another layer on this, personal tax rates are relatively low right now.
Let’s look at a simple example. You are single and making $90,000 a year right now. A promotion has come your way doubling your salary to $180,000 in two years. This means you head from the 24% income tax bracket to the 32% bracket. That’s a rather sizeable jump. Also, you have just been granted Restricted Stock worth $50,000 now that fully vests in two years. If you do not go the 83b election route, in two years the stock will vest and you will recognize compensation income of the fair market value. This amount will be added to your new salary of $180,000. Now, imagine the stock went up 20% over these two years. You are adding another $60,000 of compensation income inside that 32% marginal tax bracket. I guess a good problem to have, but the 83b election gives you an option not to tip Uncle Sam.
If you went the 83b election route when the Restricted Stock was awarded to you, you would recognize $50,000 of compensation income and add this to your $90,000 salary, but staying in the 24% marginal tax bracket. In this case, two years later you decide to sell the fully vested Restricted Stock and since you already recognized it as compensation income the new growth above $50,000 will be treated as capital gains.
This is a unique situation, but one to discuss with your CFP. A more likely scenario is one where you are highly confident the value of the Restricted Stock will be going up in value.
To me, this second example is a much riskier situation. Why? Well, because you are making the 83b election on the basis of your HOPE that the stock price will be going up in the future. Maybe this makes more sense if your company is a newer one, but there is still risk. I’m honestly not going to try and give any other examples as we all know the horror stories of companies like Enron. Those are rare situations, but at the same time there are plenty of cases like IBM, GE and Altria where the share prices have gone down the last few years. I would hate to go the 83b election route and pay taxes on Restricted Stock that ends up being worth less when the real vesting occurs.
A potential way to deal with this is to vary your 83b elections. This assumes you regularly receive Restricted Stock Awards. Maybe one year you go the 83b election route and recognize the income and taxes immediately. Then the next year you do not go that route. Just a suggestion and again something to talk through with your CFP and CPA. Ultimately, there is risk in this situation of doing an 83b election based on the hope your company stock will go up in price.
Those are the two most common situations where one might consider an 83b election. Again, and I cannot stress this enough – talk this through with your CFP. And, make sure he or she is competent with Restricted Stock and 83b elections. It is an area of specialization in my world. Just like I don’t cater to clients with student loans, not all CFPs cater to Equity Compensation holders. Finally, not all CPAs even understand the 83b election. So, do your due diligence and ask questions.
Okay, that is enough for what is an 83b election. However, I will mention 83b elections are allowed for certain types of nonqualified stock options. If you have nonqualified stock options and are wondering if the 83b election exists for you, talk to your Equity Compensation benefits people at work.
I’m Dan Johnson, CFP®, founder of Forward Thinking Wealth Management. I run a flat-fee financial planning and investment management firm located in beautiful Akron, OH. Although I am in Akron, OH, I work with clients regardless of location. I cater to owners of equity compensation positions who are looking to organize their financial lives, keep more of what they make, and do the things they want in retirement and even now.