Here’s the short answer: An 83(b) election is a process by which you exercise your stock options before they have vested with the intention of reducing your tax bill.
If reducing your tax bill sounds like a good time, read on for the long answer…
It is becoming increasingly common that companies offer their employees the ability to exercise their stock options early (before they have vested). At first, this doesn’t seem like a great offer. Doesn’t the “option” to buy represent one of the most valuable aspects of a stock option? Why would I want to give up that advantage and exercise my stock options early?
The answer, as you may have guessed, has to do with the way your options are taxed.
Traditionally, in order to exercise your options, you must first wait for them to vest at some point in the future. Presumably, the share price will rise beyond the strike price during that vesting period, representing a profitable spread that will be taxed as either ordinary income or as an AMT preference (depending on the type of option). For non-qualified stock options, the tax rate is equal to your ordinary income rate, which can be as high as 39.6%. If they are incentive stock option (ISOs), the tax will be reported on AMT at a rate that is (likely) very similar.
The idea behind exercising early and filing an 83(b) election is that you can effectively purchase the shares for which you have options BEFORE the value of those shares rises above the strike price. When you do this, you won’t have to pay tax on the spread between strike price and fair market value because (ideally) those two numbers will be the same.
Instead, assuming you hold the shares for longer than a year, you will only have to pay taxes at the much more favorable long-term capital gains rate.
Here is an example
Imagine you have been granted 10,000 options at a strike price of $2 per share. The options vest over four years.
Traditional vest and exercise:
You exercise your options after four years, when the shares are valued at $18 per share. Your spread is (18 – 2) * 10,000 = $160,000.
You pay ordinary income tax (or AMT) on this spread at 39.6%. Total tax bill = $63,360
Early exercise and 83(b) election:
You exercise your options immediately, when the shares are still valued at $2 per share. Your spread is (2 – 2) * 10,000 = $0
You pay ordinary income tax (or AMT) on this spread at 39.6%. Total tax bill = $0
Once you sell the shares, assuming you hold them for at least 12 months, you will pay the long-term capital gains rate on any difference between the $2 strike price and the price at which you end up selling the shares.
What are the risks?
The main risk here is fairly obvious; there is a chance that the company you work for will fail. If this happens, then you are in a position where you already paid to exercise your stock options and you are left with shares that are worthless. In the example above, if you exercise 10,000 options at a $2 strike price, you could potentially be out $20,000.
On the other hand, that $20,000 can be carried forward and applied as a loss against your taxable income of up to $3,000 per year.
How do you do it?
The first thing you should do if you are considering an 83(b) election is talk to a qualified tax professional who specialized in equity compensation (thankfully, we have a whole team of nerds like that at Vestboard).
Once you have done that and determined that an 83(b) election is in your best interests, you will request a form 83(b) from your employer and notify them of your intention to exercise early. You then have 30 days from the date of exercise to file your 83(b) with the IRS (we can help with that part). Don’t forget to include a copy of your 83(b) along with your 1040 (we can help with that part too).
Remember, just because you exercised early, doesn’t mean that you can actually take control of the shares prior to their vesting. You will still need to wait until the shares have vested before you can sell them. But the good news is that you will start the clock for long-term capital gains earlier and you will be able to avoid paying ordinary income tax or AMT preference on the spread.
Disclaimer: This article is intended as general information only and should not be interpreted as investment or tax advice. Vestboard makes no guarantees as to the accuracy, completeness, suitability, or validity of any information contained on this site. Each individual has their own unique circumstances which must be taken into consideration. Financial advice is only granted to individuals who become Vestboard clients. Past performance does not guarantee future results.