For many employees, it’s not uncommon to be offered company stock as part of your compensation package. Whether it’s in the form of non-qualified stock options (NSOs), restricted stock units (RSUs), or something else, getting offered company stock has the opportunity to yield much more income.
Unfortunately, more income means more taxes. However, by taking an 83(b) election, it’s possible that you can pay less in taxes on your company stocks, leaving more of your money where it belongs: in your pocket.
How Are My Stocks Taxed?
Before we get into how an 83(b) election can change how your stocks are taxed, let’s recap how your stocks are typically taxed without taking an 83(b) election.
For the most part, the gains on your shares of company stock are taxed as regular income. There are some nuances–especially if you have incentive stock options (ISOs)–but for the most part, your shares are counted as regular income when you pay your annual income taxes.
Taking it just a little further, your NSOs get taxed as regular income when you exercise your options–AKA when you decide to buy your company stock. At that point, you’re taxed on what’s called the bargain element: the difference between what you paid for your shares and what they’re worth. So, as an example, if you were granted 500 shares of stock at a grant price of $10 per share, but the fair market value of those shares is actually $50 at the time of vesting (when you’re allowed to buy your shares), then you can purchase $25,000 worth of shares for only $5,000. The bargain element in this example is $20,000, so when you decide to exercise your options, you will pay regular income taxes on the $20,000 bargain element.
This is significant because, depending on your income and how you file taxes (single or jointly), you could be paying 32%, 35% or even 37% when you exercise your shares.
What Is an 83(b) Election?
In its simplest, most basic terms, taking an 83(b) election just means that you’re prepaying the tax on your stocks. Rather than paying taxes when the shares are exercised and/or sold, you pay taxes right away on the difference between the grant price and the fair market value–the bargain element.
Let’s go back to the example above. You’re offered 500 shares of NSOs with a grant price of $10 per share. At the time of vesting, the value of those shares has increased to $50 per share. But because of your vesting schedule (how long you must wait to exercise your options), it might take a couple years for the value to reach $50 per share. When you’re granted the option, the value might actually be something like $12 per share.
If you believe in your company and feel strongly that the value of your shares will appreciate, you can take an 83(b) election and pay taxes right away on those shares–even before they vest. Since an 83(b) election means you’re prepaying taxes on the bargain element (the difference between your grant price and the fair market value), in this case, you’re paying taxes on the difference between $6,000 (fair market value of 500 shares at $12 per share) and $5,000 (500 shares at your grant price of $10 per share). That’s only $1,000 that will be taxed as regular income. Then, when you buy those stocks that are now worth $25,000, you’ve already paid income taxes on them, so the $20,000 capital gain is taxed at more favorable capital gains rates as opposed to regular income rates.
What Are the Advantages of Taking an 83(b) Election?
The benefit of doing this is that, if you really believe in your company and think the stock price is going to appreciate considerably, you can pay your taxes now, when the difference between the exercise price and market value is much lower–or potentially non-existent. Like in our example above, that would leave you to simply pay taxes on your capital gain. If you qualify, that could reduce your tax liability from possibly north of 30% down to a much more manageable 15% or 20%. In the end, taking an 83(b) election can potentially save you thousands of dollars (or more) in taxes.
Are There Risks Involved with 83(b) Elections?
Like anything you do regarding stocks, there are risks. For starters, the value of your shares might not appreciate. In fact, there’s a chance they depreciate. Going back to our previous example, you might take an 83(b) election when your grant price is $10 per share and the fair market value is $12 per share. You’d pay income taxes on the $1,000 difference, but when your shares vest, the fair market value might only be $8 per share.
Under normal circumstances, you would never exercise your options if this were to happen. You would simply let the options expire and wash your hands of the whole situation. But if you took an 83(b) election, you’ve already prepaid taxes, so you’re out of pocket. You could wait to see if the shares eventually appreciate, but that might not happen until your options expire.
Additionally, companies grant stock options as an incentive to keep employees around. You might fully intend on staying with your company for the long haul so you might take an 83(b) election on your NSOs. You would prepay your taxes and everything, but then you could get an offer for a different, better job. If you leave your company, you lose out on your stock options. That means you would have paid taxes on shares of stock you never even get to buy.
Is an 83(b) Election Right for Me?
83(b) elections, while potentially lucrative, can also be a huge gamble. The beauty of something like stock options is that you don’t have to take a risk if you don’t want to. You have the option to purchase shares of company stock and potentially make more money, but you’re not forced to. You can take a wait-and-see approach until you’re certain that your shares are appreciating in value.
By taking an 83(b) election, that option is gone. You’ve prepaid your taxes, so you’re buying those shares no matter what. You need to be as sure as you can be that your shares will appreciate and you’ll make money on the transaction.
Further, you’ll need cash-on-hand to cover the tax liability. NSOs offer the ability to do something called a cashless exercise. With this strategy, you would exercise your options and then immediately sell your shares. Any tax liability is simply taken out of your profits from the transaction. By performing an 83(b) election, you don’t have that luxury and must instead cover the tax liability out of pocket.
All in all, whether to take an 83(b) election is something you need to decide for yourself (in fact, your company might not even allow it, so check the fine print!). However, if you do decide it’s something you want to explore, it has the potential to offer significant tax savings. Talk to your financial advisor to find out if it’s the right move for you. And if you want to learn more about how non-cash compensation can be incorporated into your overall financial plan, download our complimentary eBook, The High Income Earner's Guide: Navigating Non-Cash Compensation.
