Pros & cons of electing 83(b) for ESOPs of a USA based startup

For employees receiving equity compensation like restricted stocks, Section 83(b) offers an intriguing tax strategy. It allows you to take control of when taxes are paid, potentially reducing your tax burden. However, this choice comes with its own set of risks. Let’s explore the advantages and drawbacks of electing 83(b) for your equity compensation in a US-based startup.

What is an 83(b) Election?

An 83(b) election lets you pay taxes on the fair market value (FMV) of your restricted stocks at the grant date, rather than as the shares vest.

Key points:

• The election must be filed with the IRS within 30 days of the grant date.
• Taxes are calculated on the FMV of the stock at the time of the grant.
• After the election, you won’t owe taxes as the shares vest. Instead, you’ll pay taxes only when the shares are sold.

Benefits of Electing 83(b)

1. Tax Savings on Future Appreciation

By paying taxes upfront on the grant’s FMV, any future gains are taxed as capital gains rather than ordinary income. Capital gains rates are generally lower, saving you money if the stock’s value increases significantly.

2. Simplified Tax Management During Vesting

Once you elect 83(b), you’re free from paying taxes at each vesting milestone. This can simplify your financial planning, as you won’t face yearly tax liabilities for vested shares.

3. Favorable Capital Gains Treatment

Electing 83(b) starts the clock on long-term capital gains immediately. If you hold the shares for more than a year, any gains on sale qualify for lower tax rates.

Drawbacks of Electing 83(b)

1. No Refund on Unvested Shares

If you leave the company before all your shares vest, the unvested portion is forfeited. Unfortunately, any taxes paid upfront on those shares won’t be refunded.

2. Upfront Tax Burden

You’ll need to pay taxes on the FMV of the shares at the time of the grant, even though you may not have immediate liquidity or access to the shares.

3. Risk of Stock Price Decline

If the stock price drops after you’ve made the 83(b) election, you’ll have paid taxes based on a higher value, resulting in a financial loss.

Factors to Consider Before Electing 83(b)

1. Commitment to the Company
   Are you confident in staying with the company through the full vesting period? Leaving early means forfeiting unvested shares and losing any taxes paid on them.
2. Expectations for Stock Performance
   If you believe the stock’s value will rise significantly, the 83(b) election can lock in lower taxes. However, if the stock price falls, the upfront taxes may not be worth it.
3. Financial Liquidity
   Do you have the cash to cover the taxes upfront? If not, the election might not be feasible, especially if the FMV of the grant is substantial.

Making the Right Choice

Electing 83(b) is a strategic decision that depends on your financial goals, risk tolerance, and confidence in the company’s growth. While it can offer significant tax benefits, it’s essential to weigh the risks carefully.

For more insights and examples on 83(b) elections, check out our YouTube video, where we break down the process, benefits, and potential pitfalls to help you make the best decision for your situation. Don’t miss it!