Do you work for a corporation or a partnership and are granted equity in connection with the performance of services that is subject to a vesting period? In general, for tax purposes, the equity is not a reportable and is taxable until the vesting period is satisfied.
As an example, on 2/1/2020 Individual A, an employee of Company B Inc., receives 100 shares of equity in connection with the performance of services that is subject to a 3-year vesting period. The 100 shares are worth $1 on 2/1/2020. At the end of the 3-year vesting period, the shares are worth $10. Individual A will need to include on their tax return $1,000 of compensation income and pay tax using the ordinary rates. For purposes of this example, if Individual A were subject to the highest tax rate of 37% they would pay $370 of tax.
At first glance you might tell yourself that this is a great outcome since you are deferring the payment of tax for 3 years. However, it may prove to be more advantageous to pay tax the day you receive the non-vested equity. That is where the 83(b) election comes to play. The 83(b) election allows you to report as compensation income the non-vested equity you received in the current year as opposed to waiting in the 3-year vesting period.
Using the same facts in the example above, Individual A will include in income in 2020 $100 and be subject to $37 of tax in 2020 if Individual A makes a 83(b) election. Then, when individual A receives the equity after the 3-year vesting period, Individual A does not to report any income since they already included it income 3 years prior with the 83(b) election. To continue the example, if Individual A were to sell the equity the day after the vesting period, 2/2/2023, Individual A will then need to pay tax on $900 at the 20% capital gains rate yielding a tax liability of $180. Therefore, with the 83(b) election the total tax liability across the 3 years is $217 versus the $370 tax liability without the 83(b) election.
The last and arguably the most important takeaway is that there is only a 30-day window to timely file an 83(b) election. In other words, the decision must be made swiftly in order to take advantage of the potential upside based on the examples above.
This is certainly a high-level interpretation of the 83(b) election and everyone’s situation is unique. Do not make an 83(b)election based on this article alone. Be sure to consult your neighborhood friendly tax advisor for a thorough discussion of making the 83(b) election and how it applies to your specific circumstance.
Written By: Juan Buitrago