is an option employee shareholders have under Section 83(b) of the Internal Revenue Code. It entitles them to choose when they will be taxed on shares they purchase from their employer when their shares are not fully vested.
Anyone who receives stock in connection with the performance of services for a company should know about Section 83 of the Internal Revenue Code. Unless an 83(b) election is made, Section 83 can require the shareholder to pay taxes at ordinary income tax rates when the restrictions on his stock lapse. The tax is computed on the difference between the value of the stock when the restrictions lapse and the price paid for the shares. This tax must be paid even if the shareholder cannot, as is typically the case with private company shares, sell his stock to generate cash.
Section 83(b) entitles the shareholder to make an election within thirty days after he purchases the shares to prevent this unwanted attribution of income. The election (basically, filing the proper form) causes the shareholder to be taxed at the time of the purchase, instead of the date of vesting. This earlier tax is based on the difference between the purchase price of their shares and the value those shares would have had when they were purchased if they had been fully vested.
Why would someone choose to be taxed earlier instead of later? Because, as is often the case in early stage growth companies, the initial low purchase price for the shares may equal the actual market value of those shares at that time. When this is the case, making an 83(b) election creates no tax liability at the time of purchase and prevents tax liability arising when the restrictions lapse on the stock. This effectively defers the employee’s tax obligation until he sells the stock.
Even an employee who purchases stock for less than its value, may choose to make the election. If the employee believes the stock will increase dramatically in value, he may prefer to be taxed now on a relatively small amount rather than risk being taxed on an amount which is much greater when the stock fully vests.
The chart below, which assumes that the shares were sold at a discount to the employee, illustrates the workings of Section 83(b).
As the chart illustrates, failure to make an 83(b) election can have damaging effects. If, as everyone involved hopes, the company increases in value during the vesting period, the shareholder who failed to make the election will have to pay taxes on the difference between the increased value of the shares on the date they vest and the amount he paid for them. At the same time, the shares are likely to be illiquid (unsalable) because of restrictions that apply to unregistered securities. As a result, the shareholder may owe the federal government a substantial tax payment (resulting from his choice not to make an 83(b) election) without having the means to pay it. In the example, failure to elect to pay taxes on a $2,000 gain results in the employee owing taxes on $80,000 of "paper income" when the restrictions lapse. The provisions of Section 83 are complex and cannot be completely explored here. They apply in situations when a casual observer would not think they should. As a result, any person who receives or purchases securities that are subject to vesting or other similar restrictive provisions should consult with a qualified attorney or accountant to determine whether the filing of an 83(b) election is appropriate. See: Restricted Securities, Vesting Schedules, Vesting Stock Grants.