Sometimes the situation arises in which the owners of a company want to invite a key individual to join the ownership team in return for the individual’s services. For example, an individual might have specialized training in a certain engineering process that can benefit a company. In other cases, the individual may lack sufficient resources to contribute a capital contribution in cash and the ownership team agrees to grant an equity interest for their services.
In these situations, the Tax Code (specifically section 83), states that the equity interest is taxable compensation when it vests in the hands of the individual because the interest was received in exchange for the individual’s services (no different from any employee). Under section 83, the value of the interest at vesting less any amount paid by the individual is taxed at ordinary income rates.
This is where an 83(b) election may help. If the overall value of the Company is expected to appreciate, this election accelerates the taxable compensation to the date the equity interest is received (i.e., when the value is lower) rather than the later vesting date. Consequently, the ordinary income rates will apply when the value of the interest is low, and when the service partner later sells their interest (including back to the Company), the future appreciation is taxed at more favorable capital gains rates.
For example, assume an individual is granted 1 share of restricted stock in September 2024 when the value is $10 per share. Later when the share vests in September 2026, the value is $100 per share. If an 83(b) election is made within 30 days of the grant date in September 2024, the individual is taxed on the $10 at ordinary interest rates (assuming the individual is not required to pay for the interest). Later when the individual vests and sells the stock in September 2026, the appreciation of $90 (the value in September 2026 less the value at September 2024) is subject to capital gains rates. If an 83(b) election were not made, the full $100 would be subject to ordinary income (compensation) tax rates upon vesting.
A Unforgiving 30 Day Deadline to Make the Election
The 83(b) election must be made within 30 days of receiving the equity interest. Since the election is statutory and not regulatory, the IRS does not have the ability to extend this 30-day deadline. Consequently, if it is missed, there is no relief available. The recipient of the equity interest actually makes the election and sends the election to the Company and to the IRS office where the recipient will file their tax return.
Types of Equity Interests
83(b) elections can be made when the following are issued for services:
1) Restricted Stock Grants
2) Exercised Stock Options – 30-days from the exercise date
3) Restricted Stock Awards
4) Compensatory Partnership Interests
83(b) elections cannot be made for unexercised stock options since the IRS does not view
these as “property”. As noted above, once the options are exercised, an 83(b) election can be made.
New Form Issued for 83(b) Elections
The IRS recently issued Form 15620 titled “Section 83(b) Election”. Currently, the Form is
not mandatory to use so taxpayers can still prepare their own forms and format to make the
election.
If you own a company which is considering issuing an equity interest for services or if you
may be a recipient of such an interest, see your tax advisor to discuss whether an 83(b)
election should be made.
Written by: Tom Alvarez, CPA; MBT
