Unlocking Tax Advantages: Exploring 83(i) Elections

Equity compensation has become a popular method for attracting top talent in today’s competitive job market. Employees and executives are often rewarded with Restricted Stock Units (RSUs) or Non-Qualified Stock Options (NQSOs), the vesting and selling of which can result in significant tax implications. In this blog post, we will delve into the concept of 83(i) elections, a lesser known but potentially advantageous tax strategy for certain employees. We will explore the benefits, drawbacks, and eligibility criteria for this election, and discuss how it differs from the more commonly known 83(b) election.

In the past decade, there has been a dramatic increase in the use of employee equity compensation in the form of RSUs and NQSOs. In most cases, these employees will undergo a waiting period as the grants vest, ultimately allowing ownership of these shares. It is at this time that cost basis will be established, and ordinary income tax will be owed on the bargain element. The bargain element is the difference between the exercise price and the market price on the day an employee exercises the options and purchases the stock.  It is important to note that the tax treatment of the bargain element is different for incentive stock options (ISOs) than either of the two equity types discussed in this article.

One thing is for certain: when it comes to taxes, there is ALWAYS another level to any section or update made in the Internal Revenue Code. This is where Section 83(b) and 83(i) elections come in.

What is the 83(b) election?

An RSU owner that has confidence in the growth and direction of the company may have heard of making an 83(b) election. An 83(b) election allows the owner to pay taxes early (at a time the owner feels appropriate), even before these grants have vested.

Typically, when an employee receives RSUs, they are subject to certain restrictions or conditions, such as a vesting schedule. Without making an 83(b) election, the employee would be taxed on the value of the stock when it becomes vested.

By filing an 83(b) election with the Internal Revenue Service (IRS) within 30 days of receiving the restricted stock, the individual can choose to recognize the income associated with the stock at the time it is granted. This means that any future appreciation in the stock’s value between the grant date and the vesting date is not subject to further income tax.

The 83(b) election can be advantageous if the stock is expected to appreciate significantly. By paying taxes on the value of the stock upfront, the owner can potentially benefit from the lower tax rates applicable to long-term capital gains when the stock is eventually sold.

Next, let’s welcome the lesser-known relative of the 83(b), the 83(i) election.

What is the 83(i) election?

Section 83(i) is a relatively new concept created in 2017. This election is similar to the 83(b), but is meant to help non-executive employees take advantage of their RSUs exactly like a higher earner would be able to.

Pros

When you make the 83(i) election, you can elect to defer the recognition of income (for federal income tax purposes) for up to five years. This is by far the most beneficial attribute of this election. For example, assume you have a significant RSU grant, and would like to do an 83(b), but the upfront tax implication would be more than your annual salary. By taking the 83(i) election, you can take time to save up the cash needed but still establish your cost basis earlier.

The 83(i) election is done in a similar manner as the 83(b) election, so the process is guided by existing precedent.  Like the 83(b), the 83(i) election allows you to “lock in” the cost basis, starting your capital gain “timer” at the time of election. This allows you to pay capital gains taxes at a future date instead of paying federal income taxes when the shares vest.

Cons

This election has severe eligibility restrictions; only specific stock and employees are eligible to make the 83(i) election:

• Eligible corporation – stock is not readily tradeable (e.g. private company) and at least 80% of all employees are granted stock options
• Qualified employee – cannot be a 1% shareholder, officer, or highly compensated employee

There are specific criteria that need to be followed to be able to make the 83(i) election. If the stock is transferred to an employee, an election can be made to defer inclusion in gross income until the earlier of (this list is not exhaustive):

• When the owner takes full ownership of the property (and can transfer it to someone else)
• The day the owner ceases to be part of the “qualified employee” group
• When the corporation issuing the stock is no longer a privately held company

As you can see, if you are part of a non-publicly traded company, there are considerable benefits to the lesser-known 83(i).  If you are an employee of a publicly traded company, an 83(b) election may be right for you.  Please talk with your advisor if you’re interested in learning more about these planning strategies, and consult with a tax professional before making any significant discussions on any of the topics discussed.