The Section 83(B) Election: An Important Tax Strategy

Section 83 of the Internal Revenue Code plays a critical role in determining how property transferred in connection with services is taxed, particularly when it comes to stock compensation and vesting schedules.

Enacted as part of the Tax Reform Act of 1969, Section 83 requires property value to be included in gross income when the employee’s rights are either not subject to substantial risk of forfeiture or become transferable. Substantial risk of forfeiture typically involves a vesting schedule based on continued employment or performance metrics. The gross income realized upon vesting is treated as compensation (ordinary income subject to payroll taxes), calculated as the fair market value (FMV) at vesting minus any amount paid for the property. The holding period begins at vesting, and the basis equals the consideration paid plus includible income. Any subsequent appreciation or depreciation in the stock’s value is treated as a capital gain or loss.

Rather than wait until vesting, an employee can elect to report the excess of the fair market value (FMV) of restricted stock over the consideration paid in the year the stock is granted, known as the Section 83(b) election. This election must be filed using the newly introduced Form 15620 with the IRS within 30 days of the property transfer, and a copy must be submitted to the employer. The form currently needs to be paper filed, although electronic filings are expected in the future. The election includes the FMV excess over consideration paid for the stock as ordinary income in the taxable year of the election, and the holding period begins on the transfer date. As the employee meets vesting requirements, no further income recognition is needed, and stock appreciation is tax-deferred until sold. Advantages include potential lower initial tax liability, tax deferral on gains, and starting the holding period for long-term gains and potential qualified small business stock (QSBS). However, disadvantages include capital loss limitations if the stock value decreases and no recovery of taxes if the stock is forfeited. Employees should consider employment stability, company performance, and the ability to pay the tax liability before making the election.

In summary, the 83(b) election provides for potential tax savings, both up-front and in total. Despite the temptation of potential tax savings, the employee should consider whether they will remain employed at the company meeting performance metrics during the vesting period, if the company’s stock valuation is expected to increase, and if the tax liability associated with the election is affordable. Then, the employee can decide on the applicability of the 83(b) election. If you have questions about the section 83(b) election form, please contact your Withum tax advisor.

Author: Kristyn Amato, CPA | [email protected]