A timely and correctly filed 83(b) election for early exercised stock options or restricted stock awards (RSAs) could result in serious tax savings, especially for shares of early stage companies with significant future appreciation in value.

What is an 83(b) Election?

Filing an 83(b) election is notifying the IRS that you would like to be taxed on eligible shares at grant/early exercise and not at vest; you are paying the tax before you have the shares in your full possession. As a result, the amount of ordinary income recognized on the grant might be significantly reduced, since the spread between cost of shares and their fair market value (FMV) might be much lower at 83(b) filing than at vesting.

In addition, by electing the earlier taxation, you are starting the clock on the holding period and not waiting until vesting, making you eligible for the lower long term capital gains tax rates sooner.

The two general pitfalls associated with opting for a 83(b) filing are:

If you end up selling the shares for less than your cost basis, the deduction is a capital loss, subject to annual limitation unless there is a corresponding capital gain to offset the loss carried forward.
If the stock is forfeited, your deduction is limited to the amount you actually paid for the shares, also as a capital loss. The previously recognized ordinary income is not included in that deduction.

We are going to look at implications of an 83(b) filing for the following types of equity compensation:

Non-Qualified Stock Options (NSOs or NQSOs)
Incentive Stock Options (ISOs)
Restricted Stock Awards (RSA)

Note: An 83(b) election can NOT be filed for Restricted Stock Units (RSUs). RSUs are taxed at vesting based on FMV on vesting date, and that can’t be changed.

83(b) and Non-Qualified Stock Options (NSOs)

Scenario: No early exercise and no 83(b) election:

At grant, you are given a chance to buy stock at a fixed price at a future date, and that price is usually the FMV on the grant date. No taxation takes place at grant. Once the options vest and you exercise, the difference between FMV on exercise date and your exercise price becomes ordinary taxable income subject to tax withholding.

When you sell at a gain at least a year after exercise, capital gains rates will be applied to the difference between the sales price and the FMV on exercise date. To learn more about Non-Qualified Stock Options, you can check out this article here.

Scenario: Early exercise and an 83(b) election:

If you can exercise your options before they vest (do an “early exercise”), an 83(b) election could be of service. You early exercise your options at your strike price; the difference between FMV and exercise cost becomes ordinary taxable income subject to tax withholding. If the exercise is done near the grant date, cost and FMV are usually the same, hence no taxable income to be recognized. An 83(b) election is filed within 30 days from that early exercise. In this scenario, there is no taxation at vesting since you elected to be taxed at exercising.

When you sell at a gain at least a year after exercise, capital gains rates will be applied to the difference between the sales price and the FMV on exercise date.

When should you exercise NSOs early and file an 83(b) election?

If you are “very confident” about future value appreciation, planning to be around for vesting, and/or expecting to sell a shares at a significant gain during an exit event less than one year from vesting, then filing an 83(b) is usually the right choice.

When should you NOT do an early exercise and 83(b) election of NSOs?

Risk of forfeiture if you’re not employed at time of vesting: your future deductible loss might be limited to the amount paid for the shares excluding the tax paid on the spread. And that loss might only be used to offset qualified future gains or deducted at $3,000 per year.
Risk of significant loss in value: you will not be able to capture the decrease in value until shares are sold, and even then it would be a capital loss subject to the limitations mentioned above.
Large tax bill from the 83(b) and general cost of exercise: if you have to borrow money to finance the exercise solely for the benefit of potential better tax rates, there could be even more reasons against that decision.

83(b) and Incentive Stock Options (ISOs)

The advantage of ISOs is that there is no income recognition on the spread between FMV and exercise price until shares are sold, assuming the holding period is at least 2 years from grant and 1 year from exercise. However, that “spread” is considered income for AMT purposes, also known as the “AMT trap” of ISOs. Because there is no regular tax recognition on ISO exercises, an early exercise (and an 83(b) filing) of ISOs will not result in a regular tax bill but could trigger AMT tax. The strategy of filing an 83(b) election for early exercised ISOs is primarily focused on reducing AMT tax and does NOT start the clock on holding period for regular tax.

Should you convert ISOs to NSOs (assuming your company offers that option)?

If you are planning to dispose of the ISO shares within two years from grant and one year from exercise, then the “disqualifying disposition” rules would kick in: the spread between FMV on vesting and strike price would become ordinary compensation income, with the remainder of the gain being either short-term or long-term gain depending on holding period.

If you converted those ISOs to NSOs and did the early exercise routine, there would likely be no compensation income component, just either short-term or long-term gain on the difference between sales price and strike price.

When does it make sense to exercise ISOs early and file an 83(b) election?

An 83(b) election for ISOs can help minimize the associated AMT bill, so if you are expecting to “be in AMT” when exercising at vesting, doing the early exercise routine for ISOs might reduce your AMT bill.
If you are not expecting to “be in AMT” when exercising ISOs, there might be no point to rush in and potentially generate all that AMT income with an early exercise and an 83(b) election.

83(b) and Restricted Stock Awards (RSAs)

Scenario: No 83(b) election: At grant, you either receive shares as an award or you purchase them at a stated price, usually with outside money; no taxation takes place. When shares vest, the “spread” (the difference between FMV on vesting day and your original purchase price, if any) becomes taxable wages subject to tax withholding. The cost basis in your shares is FMV on vesting date. When you sell the shares, long term capital gain treatment is available after one year from vesting date on the growth from the price at vesting.

Scenario: With an 83(b) election: At grant, you either receive shares as an award or you purchase them at stated price, usually with outside money. You file an 83(b) election within 30 days from the grant. If there is a spread between FMV and your cost, that value becomes taxable income subject to tax withholding. Your cost basis is the FMV on grant date. When shares vest, no taxation takes place. When you sell the shares, long term capital gain treatment is available after one year from the grant date on the growth from the price at exercise.

When does it make sense to file an 83(b) for Restricted Stock or RSAs?

If you are anticipating shares to appreciate significantly and are planning to stick around until vesting, then filing an 83(b) for RSAs is a clear choice.
If there is a significant risk of forfeiture, loss of value, and/or there is significant tax to pay in conjunction with electing to file an 83(b), the answer is not straightforward - that money could be effectively gone with not even a tax deduction to use in the future.

How to file an 83(b) election:

There is no official 83(b) form. The custodian of your shares (Carta, ShareWorks, FIdelity, E-trade, Schwab, etc.) should have a template for you to fill out. There is a sample on the bottom of this page.

First, generate three copies. The very strict deadline is 30 days from exercise (options) or grant (RSAs).

The first copy gets sent to the IRS using the address based on your state of residence via certified mail with a return receipt. It is the same address where you would mail your tax return.
The second copy goes to your employer.
The third copy is saved in your personal tax file. You no longer need to attach it to your tax return.

What happens if I do an early exercise but forget to file an 83(b) election?

Failure to file a timely 83(b) election puts you back into the position of recognizing income upon vesting on the spread between cost and likely higher FMV on the day of vesting instead of on early exercise/grant date on the spread between cost and the likely lower FMV on early exercise/grant date, which can result in significant ordinary income if the value of stock shoots up. Effectively, you paid for the shares but don’t yet own them until vest.

SAMPLE 83(b) ELECTION LETTER:

Your name and address

Department of the Treasury Internal Revenue Service Center

Re: Election under Code Section 83(b)

Dear Sir or Madam:

I hereby make an election pursuant to Section 83(b) of the Internal Revenue Code of 1986, as amended, with respect to certain restricted stock received by me. The following information is submitted as required by Treas. Reg. § 1.83-2(e):

Name, address, and TIN/SSN of the taxpayer:
Description of the property (number of shares, name of the company):
Date of transfer of the property:
Taxable year for which election is made:
Restrictions to which property is subject:
Fair Market Value of the property:
Amount paid for the property:

A copy of the election is furnished to the Corporation.

Best regards,

Signature, Date, Name

State, ZIP code