If you receive stock options from your employer, you may have the opportunity to significantly lower the taxes owed from exercising those options.
Section 83(b) election could save you thousands of dollars in taxes by paying a long-term capital gain tax rate versus the generally higher ordinary income tax rate. Some companies don’t allow 83(b) elections, so it’s important to read your plan document and understand your employer’s rules in advance.
How 83(b) works
Upon receiving your stock grant, you have 30 days to send documentation of your election to the IRS and your employer. You’ll pay income taxes on the option’s “spread value”—the share’s market price on the day you made the 83(b) election minus the option’s exercise price, which is usually less than the spread value at a future exercise date. If you hold the option for at least a year from your award date, any subsequent gain recognized will be taxed as long-term capital gains rather than ordinary income.
If you don’t make an 83(b) election within that 30-day window, your recognized gain will be taxed as ordinary income instead. Those tax consequences could be large if the share value rises significantly. An example of the potential tax-saving benefit on non-qualified stock options (NQSOs): Let’s say you receive 10,000 NQSOs that vest in a year with an exercise price of $9 per share. One week later, you make an 83(b) election when your employer’s stock price is $10. Making an 83(b) election, you would pay income tax on the $10,000 initial spread value ($10 - $9) x 10,000—which would be $3,700, assuming you’re in the 37% tax bracket. When you exercise your options, you’ll pay capital gains tax on the subsequent gain (the price you sold minus the price you paid). If you exercise when the share price is $60, you’ll pay $119,000 in capital gain taxes on approximately $500,000 of gain [($60 - $10) x 10,000], assuming a 23.8% capital gains rate.
If you don’t make the 83(b) election, you will instead pay that 37% ordinary tax rate on the difference between the exercise price and the market value on the date of your exercise. In this example, you’d be paying $188,700 [($60-$9) x 10,000 x 37%] vs. $119,000.
If you think your employer’s stock value could rise significantly, making an 83(b) election makes sense.
If you make an 83(b) election and the stock value declines during the period you own it, you’ll have needlessly paid taxes. 83(b) elections are generally irrevocable. Before making an election, it’s important to evaluate the probability of your employer’s stock price rising.
Know your plan
An 83(b) election is just one of the potential ways to maximize your employer’s employee stock option plan and minimize taxes. Each employer’s stock agreement is different, so it’s important to familiarize yourself with your plan and consider ways to take full advantage of it and to consult your investment and tax professionals before making a decision.