Many people associate taxes with a single date: April 15. In reality, however, tax planning should be a part of your financial life throughout the year.
For example, tax planning can and should be incorporated into investment decisions, charitable giving, and business planning. And in some cases, taxpayers face decisions long before April that can create big impacts when they finally file their returns. For example, those who receive property as stock distributions from employers may be faced with the question of whether to hold an 83 (b) election. But before taking advantage of this technical tax planning, they have to know what it is and if it is available to them, and they must act on that information promptly.
To understand what an 83 (b) election is, let’s begin with a review of a related part of the tax code. Section 83 (a) of the Internal Revenue Code governs the taxation of property transferred to an employee in exchange for services. For example, if you work at a startup and receive company shares as part of your compensation, Section 83 (a) says that income represented by the fair market value of those shares does not have to be included in your taxable income until know you will keep it (for example, when you consolidate) or the shares become transferable (that is, you could sell or give them away). The rule says that property is taxed from the first time it is transferable or is not subject to substantial risk of forfeiture, whichever comes first.
But what if you wanted to speed up the process for tax purposes? Section 83 (b) allows you to do so without waiting for the trigger provisions of the previous rule. If the person receiving the property chooses to include its fair market value in their gross income in the tax year in which the transfer is made, the tax base will be the fair market value of the shares at the time of transfer, minus what was paid for the property, if at all. Making an 83 (b) election circumvents the Section 83 (a) rule for the property in question. However, there is a risk involved. If you lose or confiscate the property because it was restricted at the time you paid your taxes, you cannot take a deduction for the amount you already included in your election income or for the taxes you paid as a result. If you later sell the property, you must also pay capital gains tax on any appreciation after the time of transfer.
In exchange for these risks, an 83 (b) choice offers some clear benefits. If the shares become more valuable between the time of transfer and the time they are consolidated, you successfully blocked ordinary income tax for the least amount. Also, making the election starts the capital gains holding period clock, which means that if you sold the stock more than one year after making the election, you would pay capital gains tax at the rates of long term. Of course, if the value of your shares decreases, you have paid more than you could have paid if you had waited. And since an 83 (b) election is irrevocable, there is no way to undo the decision, unless the commissioner of the Internal Revenue Service grants a special exemption.
There are a few other reasons why you might make an 83 (b) choice, despite the risks. For example, if the property’s value is nominal at the time you receive it, the tax may be so insignificant that it makes sense to pay it immediately in the hope of avoiding a higher tax bill in the future. Taking this a step further, if you expect the property’s value to increase substantially before your interest is consolidated, you may be concerned that you will not be able to pay the tax when it is finally due. For taxpayers who pay the property’s fair market value first, opting to pay fair market value tax on what was paid would mean no tax is owed. Some taxpayers may wish to make the 83 (b) election simply to begin the capital gains holding period.
It’s important to note that while making an 83 (b) choice carries risks in the form of potentially overpaying taxes or paying property taxes you could lose, not making that choice carries risks of its own, as noted. above. If your property appreciates substantially between the time you receive it and the time it is granted, you may have a substantial income tax liability, even if you don’t sell the property.
Here’s how it could unfold. Abby and Jennifer are hired on the same day for identical roles in a company. After their first year, each is awarded a restricted stock award. The grant has a purchase price of $ 1 per share and is subject to a four-year vesting period. They each decide to accept the grant, and Abby quickly files an 83 (b) choice, but Jennifer doesn’t.
At the end of the first year, the company’s stock has appreciated to $ 100 per share. Jennifer recognizes $ 99 per share as income (the value less the purchase price) of the part that is consolidated, although she does not sell her shares. Abby does not recognize any additional income, as she made her choice a year earlier. Over the next several years, as the shares continue to be purchased, Jennifer earns income equal to the difference between the fair market value of the shares at the time of consolidation and the purchase price of $ 1 per share. Abby, having accelerated revenue recognition, does not. Assuming both partners stay on until fully vested, Abby gets ahead due to her lower income tax liability. Abby also has access to long-term capital gains rates earlier as she started her holding period clock early.
Of course, an 83 (b) choice is not always appropriate. Consider a newer employee, Frank, who joins the company a year later when the stock is already at $ 100 a share. Frank will need to carefully consider whether he expects the share value to rise, fall or stay the same during his vesting period. Or, going back to Abby, if you need to leave the company in 10 months and before any of the shares have been acquired, you will have paid taxes on the shares that you ultimately lost. When making the choice, it is always important to realistically weigh the probabilities of future results.
If you have stock options in a private company, instead of receiving shares outright, you won’t have to worry about 83 (b) elections unless you use stock options to buy uninvested shares. And if you receive shares with no allotment restrictions, you won’t have to worry about an election at all.
How to make an 83 (b) choice
A taxpayer wishing to make an 83 (b) election must do so immediately upon receipt of the property in question, within 30 days of receipt. The taxpayer, of course, must notify the IRS, and must also notify the employer (or whoever granted the property).
While the IRS has created hundreds of tax forms for all kinds of situations, interestingly, there is no official form for those who want to participate in the 83 (b) elections. Instead, taxpayers should send a letter to the IRS office where they file their income tax returns. The IRS has provided some sample language for such a letter in the 2012-29 Revenue Procedure. While this language is not required, it is an example that would satisfy agency regulations. Information that the IRS suggests taxpayers should provide when making elections includes:
A statement of the election. In sample language, this statement reads: “The undersigned taxpayer elects, pursuant to section 83 (b) of the Internal Revenue Code of 1986, as amended, to include in gross income as compensation for services the excess ( if any) of the fair market value of the shares described below over the amount paid for those shares “.
The taxpayer’s full legal name, address, social security number, and tax year associated with the election.
A description of the property (for example, “1,000 shares of Jennifer and Abby’s Company Inc.”)
The date the property was received
The restriction that will cause the seizure if not met or the restriction that will expire when the acquisition requirements are met.
The fair market value of the property, without restriction, at the time the taxpayer received it.
Any money paid for the property.
The amount to include in gross income (i.e. fair market value less everything paid)
A statement on the presentation of the election. In sample language, this return reads: “The undersigned taxpayer will file this election at the Internal Revenue Service office where the taxpayer files their annual income tax return no later than 30 days after the date of transfer of ownership. A copy of the election will also be delivered to the person for whom the services were rendered. In addition, the undersigned will include a copy of the election with his or her income tax return for the taxable year in which it is transferred. the property. person who performs the services in relation to which the property was transferred. “
As the closing statement implies, a copy of the letter must be sent to the person who granted the property, usually an employer, and a second copy must be included with the income tax return for the year. (And, of course, a copy should be kept for personal records.) As with anything mailed to the IRS, an acknowledgment of receipt will show that the letter was submitted to the agency on time.
Taking the time to understand 83 (b) elections and make a timely decision about them can save you a lot of tax liability in the long run. It’s just one of many ways that staying in a fiscal mindset throughout the year can make the month of April happier.