Understanding the 83(b) Election for Early Exercise of Employee Stock Options
When working at a tech company in its early stages, a common tax tactic used by the founders and executives around their equity compensation is the 83(b) election. Yet, even today, many in the tech world are unaware of this potentially potent tax-saving strategy, no less know when it is appropriate to deploy.
So, that led me to write this post on what the 83(b) election is, how it works, reasons to do it, and risk factors to consider before ultimately going down this route.
What is an 83(b) Election and How Does it Work?
An 83(b) election is a section of the tax code that allows employees or startup founders to potentially reduce their tax liability when they receive stock options or other equity compensation. This election is specifically relevant to the early exercise of stock options (before they have vested), particularly in private companies or startups.
When an employee is granted stock options, they have the right to purchase shares at a predetermined price (the exercise price) at some point in the future. If the employee exercises their options early without an 83(b) election, they will be taxed on the difference between the exercise price and the stock's fair market value when the stock vests. Meaning, if the stock's value increases significantly over time, the employee could face a substantial tax bill.
However, by filing an 83(b) election, the employee can choose to be taxed at the time of the stock's grant rather than at the time of vesting. This means they pay taxes based on the difference between the exercise price and the fair market value at the time of exercise, which is often negligible if the company is in its early stages.
Why Would a Tech Execs Consider Early Exercising Their Employee Stock Options and Filing an 83(b) Election?
Minimize Tax Liability
Executives exercise early and file an 83(b) election to minimize their tax liability. When the company is young, and the stock's fair market value is low, the tax owed upon exercise is minimal. If the company's value increases substantially over time, the executive avoids paying higher taxes on the increased value.
Start the Capital Gains Holding Period Early
By early exercising and filing an 83(b) election, the executive starts the clock on the holding period for long-term capital gains tax treatment. Long-term capital gains are taxed at a lower rate than ordinary income. If the stock appreciates over time and is held for more than a year, any gain from the sale of the stock will be taxed at the long-term capital gains rate, which is usually more favorable than ordinary income tax rates.
Align Interests with Company Growth
Early exercising stock options can also align the executive's interests with the company's growth and success. As a shareholder, the executive benefits directly from the company's success, which can be a motivating factor. This alignment can foster a stronger sense of ownership and commitment to the company's long-term goals.
Flexibility in Financial Planning
Filing an 83(b) election and early exercising stock options can provide more flexibility in financial planning. The executive can make decisions about when to sell the stock based on market conditions and personal financial goals. This flexibility can be particularly advantageous if the executive anticipates needing liquidity for personal expenses, investments, or other wealth planning objectives.
The Risks and Considerations
While the benefits of early exercising and filing an 83(b) election are significant, there are also risks and considerations to keep in mind:
- Risk of Loss: If the company fails or the stock value declines, the executive could end up paying taxes on stock that has lost value or become worthless.
- Cash Flow: The executive needs to have sufficient cash flow to cover the cost of exercising the options and the associated tax liability at the time of exercise.
- Filing Deadline: The 83(b) election must be filed with the IRS within 30 days of exercising the options. This deadline is necessary for the executive to retain the potential tax benefits.
The Bottom Line: For technology executives in startups or growing companies, the 83(b) election presents an opportunity to manage tax liability strategically and take advantage of favorable tax treatment on potential future gains. However, it requires careful consideration of the risks, personal financial situation, and a thorough understanding of the company's growth prospects. This is where we can come in as your trusted wealth manager and planner to navigate these complexities and help you make informed decisions.
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Matt Faubion, CFP®
Founder - Wealth Manager