By Jarrett Topel and Gavin DiStasi, financial advisors on NerdWallet’s Ask an Advisor.
In the five years since the height of the last recession, the market has seen a steady increase in the number of companies going public. In 2013 alone there was a year-on-year increase of almost 75% in the number of IPOs in the US market. Our firm, being so close to Silicon Valley, works regularly with clients in the technology sector, and our workload the past few years certainly supports those numbers. As a result, more and more clients are coming to us with questions relating to their stock grants/options and are keen on learning strategies to help manage the oftentimes complex vesting, liquidation and realization schedules and alternatives available to them.
Unfortunately, in far too many cases, one of the most powerful tools available to these clients—the Section 83(b) election—is no longer available by the time they come to us, and it can end up being quite a costly opportunity gone by.
When a founder or early employee of a company is granted stock, that stock is often restricted and subject to a vesting schedule—set up by the company to determine when the employee or founder acquires full ownership of the granted stock. This can create a tax problem for them if not handled correctly. In many cases, the value of that stock is very low or even worthless at the time it is granted, but by the time it vests it may have gained considerable value. At that point, the difference between the original grant price (or exercise price for an option) and the fair market value at vesting needs to be reported to the IRS as income.
However, if the client decides to make a Section 83(b) election, he or she can choose to pay income tax on the shares at the time they are granted, as opposed to when they actually vest. This has two positive consequences: First, as mentioned previously, the value at the time of grant is often quite low, or the exercise price and the fair market value of an option may be equal, so the tax burden is likely insignificant. Second, once the 83(b) election is made, the clock starts on the one-year holding period for capital gains rates, which means that when the shares do vest and are liquidated, any increase in value will most likely be taxed at capital gains rates (currently 15-20% for federal) rather than ordinary income tax rates (up to almost 40% for federal).
The effect of the 83(b) election can result in substantial tax savings in certain situations, but the election must be made within 30 days of the stock being granted, which is why it is important to seek advice quickly when faced with this scenario.
We recently met with a new client whose situation clearly highlights the point.
Ted is a software engineer at an early stage biotech company, where he has been working for the past three years. As part of his contract, he was granted 50,000 shares with an exercise price of $.50/share spread over a four-year vesting schedule. During the next three years, as shares vested, Ted exercised 25,000 shares at an average price of $3/share, paying $12,500 to exercise and $27,500 in ordinary income tax (35% federal, 9% state) for a total cost of $40,000.
At the time he came to us, the company was completing a new round of funding in anticipation of going public, and shares were valued at $16. That means the remaining 25,000 shares would cost Ted $12,500 to exercise and roughly $170,500 in ordinary income tax, for a total of $183,000. This would bring the total cost of exercising all shares to $223,000.
If, however, Ted had made the 83(b) election at the time the shares were granted, he would have paid no income tax (since the exercise price and the fair market value of the shares were the same at that point), and would eventually have paid the $25,000 cost to exercise all 50,000 shares at $.50/share.
Now let’s assume the company goes public in 18 months as planned, and after the IPO, is trading at $24/share. Without having made an 83(b) election, if Ted wants to cash out of all of his shares (which all will have vested by then), he will pay $126,000 in taxes on the first 25,000 shares (capital gains rates on the difference between the $24/share sale price and the $3/share value at exercise), and $48,000 in taxes on the remaining 25,000 shares (capital gains rates on the difference between the $24/share sale price and the $16/share value at exercise), for a total of $174,000. Add that to the original $223,000 cost of exercising the shares, and he is looking at a total cost of $397,000. Since the total proceeds of the sale (50,000 shares at $24/share) are $1.2 million, Ted will realize a net of $803,000.
In contrast, let’s look at the results if he had made the 83(b) election. At the time of sale, Ted would have to pay $282,000 in taxes (capital gains rates on the difference between the $24/share sale price and the $.50/share value at the time of election). Add that to the original $25,000 cost to exercise all shares and he incurs a total cost of $307,000. When subtracted from the total sale proceeds of $1.2 million, Ted would have realized a net of $893,000. This means he would have saved approximately $90,000 in taxes by making the 83(b) election.
In this example, the right choice was to make the 83(b) election and save a substantial amount in taxes, but is there any scenario in which it could have gone wrong? What if the company does not go public, or worse, folds? At that point, Ted would certainly be out the $25,000 it cost to exercise all of the shares. However, even if the company folded, he would still be much better off having made the 83(b) election, because without it, he would also be out the $198,000 he paid in ordinary income tax along the way by exercising shares as they vested.
Of course, there are situations in which the 83(b) election can go wrong. Mostly this occurs when an employee is with a more mature company, and the shares granted have a significant value already. Because a client making the election is essentially betting that the value of the company will continue to go up, and since exercising the options of a more mature company can carry a significant upfront cost, the risk of losing that bet in the event the company goes down in value becomes more significant.
Using the Section 83(b) election can be a powerful tool in the right situations, but the key takeaway for company founders or employees who are granted stock or options is to seek professional advice on both the financial planning and tax planning sides as early as possible to ensure they can take advantage of the strategies available to them.
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. The scenario mentioned is a hypothetical example and is not representative of any specific situation.