Tax planning for equity compensation generally has two objectives – planning the income characterization attribute and planning the timing attribute:
- Planning the income characterization attribute: the objective is to convert ordinary income to capital gain, since capital gains are generally taxed at more favorable rates.
- Planning the timing attribute: the objective is to control when income is recognized and tax.
Understanding IRC SEC. 83(b) Election
A powerful strategy in achieving both income characterization and timing planning results is the Sec. 83(b) election. Just to be clear, the election is for unvested grants only. It does not apply to vested grants. For vested grants, especially incentive stock options (ISOs) and employee stock purchase plans (ESPPs), separate strategies apply.
Why Exercise Unvested Stock Grants?
Generally, grant recipients may not exercise their grants and options until they are vested. Sometimes though, companies allow early exercise…that is, allowing employees to exercise unvested grants and options. The objective of exercising unvested options is to own the stock before substantial appreciation occurs, and Sec. 83(b) election allows the employee to accelerate the recognition of income to the time of exercise prior to vesting. In fact, it is difficult to imagine that it would ever be wise to exercise unvested options and not make a timely Sec. 83(b) election.
Why is 83(b) election necessary?
Internal Revenue Code Sec. 83 provides that stocks received as compensation for services
are recognized as income only when they are (a) fully transferable, and (b) that they are no longer subject to substantial risk of forfeiture (e.g., termination prior to vesting). Accordingly, when an employee exercises unvested options, and since both conditions still present, income recognition is delayed…until such future time when both conditions are met.
By filing a timely election under Sec. 83(b) of the Internal Revenue Code, the employee may accelerate income recognition to the time of exercise. This strategy is particularly applicable when the employee believes that the stock’s value will continue to escalate through vesting; and by exercising early with a timely filed 83(b) election, the employee can lock in the ordinary compensation income amount (i.e., excess of the stock’s fair market value at the time of exercise over exercise price) before further escalation, while starting the stock holding period running so future sales would generate capital gains (and losses) taxed at more favorable rates.
When to make the election?
The election must be made within 30 days of transfer. For stock options such as NQSOs and ISOs, it means when the options are exercised. You see, a stock option grant is no more than a right (not an obligation) to buy company stock at a certain price. Until that right is exercised, there is no transaction, and therefore no ‘transfers’ as the term is used in IRS regulations. For other option- like plan arrangements, such as restricted stocks and stock appreciation rights,
‘transfer’ could mean grant, since there is no
‘exercise’ on the part of the grantee.
This 30 day rule is very strictly enforced, and there are no extensions. And it is 30 calendar days, not 30 weekdays. And it includes holidays and weekends.
How to make the election?
IRS regulations stipulate that two copies of the election statement be filed with the IRS office where the employee files his or her income tax returns. The first copy must be filed within the 30 days period as described earlier. To document the timely filing, it is best to send by certified mail with return receipt requested.
The second copy is filed with the employee’s timely filed personal income tax returns (including extensions) for the taxable year in which the option is exercised.
Incidentally, don’t forget to also file a copy of the election statement with the employer company.
It is not uncommon that people forget to attach the election statement with their income tax returns. In fact, it happens quite frequently. In 2014, the IRS issued a private letter ruling (PLR 201405008) saying that an election would still be valid in spite of the fact that it was not attached to the personal tax returns. Like all private letter rulings, this PLR applies only to the specific case to which the ruling is sought, and it is subject to the disclaimer that the ruling cannot be cited as precedent. Notwithstanding the above, the indication seems to be that as long as the 30 day filing is met, it is likely (although not certain) that the IRS will treat the election as valid.
Now…exercising options early (even with a timely filed 83(b) election) is not without risk.
There are two potential risks: one is that the stock value goes down after exercise…and meanwhile, money is tied up in the stock and taxes have been paid on the recognition of ordinary income on the early exercise.
The second risk is if there is a forfeiture event (such as termination before the stocks are vested.) When this happens, the employer company would most likely exercise its repurchase option (i.e., buying back the stocks at the employee’s exercise price.) When stocks are resold back to the issuing company, gains and losses are computed, and the exercise price is used as the cost basis despite the fact that compensation income was recognized.
For example: Jack exercised his options early at $10 when the stock is trading at $12, so he recognizes $2 compensation income upon exercise (with the timely filing of a Sec. 83(b) election.) Jack does this because he thinks the company stock price would continue to soar.
Now let’s say for whatever reason, he had to leave the company before the stocks vest. Now, the company exercised its repurchase option and buys the stocks back from Jack at his $10 exercise price. Even though Jack had paid $10 per share and recognized $2 per share compensation income, Regulation 1.83-2(a) provides that his basis in such forfeited stock, for purposes of computing gain or loss, is his exercise price, NOT the fair market value of the stock on the date of exercise, as it would be if he did not forfeit the stock and eventually sold it.
Tax Reporting for Equity Compensation Plans
See exhibit “Equity compensation plan tax treatment summary” in the PDF version here.
Equity compensation packages can be powerful wealth accumulation vehicles. It should be considered in conjunction with your personal financial goal. Use the decision criteria that I shared with
you in this whitepaper to help make your option exercise decisions.
Don’t let the tax tail wag the body of your financial dog.