83(b) Election: What is it & How to File with IRS

How Section 83 b Election can Minimize Tax Consequences

83(b) Election 

How Section 83 b Election can Minimize Tax Consequences: The concept behind making an IRC 83(b) election is the idea of minimizing future tax liabilities by electing to pay certain taxes at the current time on the receipt of stock — that may not otherwise vest or have any additional value. In the common situation, a US Taxpayer is hired by a new company and receives some restricted stock that vests at a future date(s). The company is new, and while hope springs eternal — the value of the stock is currently worth a penny for each share. By making an 83(b) election and electing to pay tax on the receipt of the non-vested shares, then when the stock vests and (hopefully) increases in value — the taxpayer will only have to pay capital gains on the difference when they sell the stock — and not income tax at the time of vesting. Let’s work through an example of how the section 83(b) election works.

How a Section 83(b) Election Works

Like everything else in tax, this section can be much more complicated than our summary below – and there are always exception, exclusion and limitations to be aware of (read: speak with a tax specialist if you are making an 83(b) election).

83(b) Election Example

Michelle gets a job with XYZ Corporation. XYZ Corporation wants to motivate Michelle, so upon accepting the offer, they offer Michelle non-vested stock options. It is a relatively new company and the stock options are only worth $.10 each;  Michelle received 10,000 shares.

Michelle’s stock options will not vest for another two years.

In other words, she will not have access to the stock for at least two years – the purpose being Michelle has to prove that she is a long-time employee and wants to remain with the company (in addition to certain laws that require a waiting period before vesting)

Does Michelle have an IRC 83(b) Tax liability now?

This is where section 83(b) kicks in. If Michelle wants to she could pay tax now on the value of the unearned stock.

In other words, the stock is worth $1000. Therefore, if Michelle was to claim the current stock as income in her current tax return, she would pay an additional tax on those earnings now.

Why would Michelle make an 83(b) Election

The main reason is Michelle hopes that the company increases in value exponentially. Therefore, of course the value of Michelle’s shares will also increase. As such, she can offset a full ordinary income tax base by making payments now and achieving capital gains rates instead.

Example of the 83(b) Election Analysis

Think of it like this: The stock is currently worth $.10. Michelle pays income tax on it now and she owns 10,000 shares at an overall base of $1000 (presume they are all in the same lot). In two years from now the stock is worth three dollars a share. As a result, if Michelle was to wait three years to pay the tax, Michelle would have to pay income tax on $30,000 of income.

Why? Because now that the stock is vested, Michelle has to claim the vested stock as income. It is not yet capital gain since it is being earned from the work performed by Michelle and not from the sale of the stock.

But it is also Capital Gain…

Continuing from the above example, if Michelle paid income tax at the time she received the shares ($.10 per share) as opposed to when she had the shares vest ($3.00 a share) the overall tax liability will be much different, and in this case much more beneficial to Michelle in the future.

In the fourth year, Michelle sells the stock for $4.00 per share.

Here’s how the difference in the analysis works:

*For this analysis, presume Michelle is in the 30% tax bracket and their long-term capital gain rate is 15%.

$.10 Per Share with 83(b) Election

Michelle owns 10,000 shares with the base of $1000. In the fourth year she sells the stock for four dollars. As a result, Michelle will pay long-term capital gain on the additional money received.

• $.10/per share of ordinary income per share when received (30% Tax)
• $3.90/per share of long-term capital gain when they are sold (15% Tax)

$3 Per Share & No 83(b) Election

Michelle waited to pay the income tax until the stock vested. Michelle is highly risk-averse and the idea of paying any additional tax on income that she may not receive, is not something she could pull the trigger on. For example, if Michelle paid the income tax on the initial $.10 a share, but the company went under before it becomes profitable, then Michelle’s paid tax on income that she will never see.

Luckily, the company does well but Michele’s tax base is much different

• • • $3/per share dollars of ordinary income (30% Tax)

    • $1/per share of long-term capital gain when they are sold (15%)

In this particular scenario, Michelle will end up paying significant more tax, since she waited for the stock the vest, which will make the majority of Michelle’s earnings as ordinary income instead of capital gains.

Foreign Companies and Possible FATCA/FBAR Reporting

The next issue becomes whether this money must be reported to the IRS and what type of account reporting will Michelle have to do. Michelle is a US citizen working abroad. Therefore, Michelle is subject to worldwide income and citizen-based taxation.

Ordinary Income

Michelle will have to report the income in the year she claims the income. In other words, if Michelle was to pay tax during the first year and claimed the income, she would reported on tax return for that year. Conversely, if Michelle waited for two years, she would not have to report the income in the first year, because technically she has not earned it yet.

Is the Foreign Income Exempt?

No. Simply because the earnings are earned abroad does not mean that they are exempt in the United States. While the country of origin of the company has rules exempting this type of income from a startup company within the first five years, the United States does not have an equivalent rule — and therefore the income is taxable.

Foreign Tax Credit

If Michelle had to pay foreign tax on the earnings (the above referenced rule does not apply to non-citizens of the foreign country), then she will receive a credit for the taxes already paid in the foreign country so that she does not have to double pay those taxes in the United States. 

To claim the credit, Michelle will file a Form 1116 along with her tax return.

Foreign Earned Income Exclusion

This is a very complicated issue and is twofold:

As to the portion that is being taxed as ordinary income, you may be able to try to exclude the income under the foreign earned income exclusion, but it is a very complex analysis and more likely than not the IRS will fight you every step of the way (this should not necessarily be a deterrent if you have a reasonable argument)

As the portion that is being taxed as capital gain, you would not be able to exclude it, because it is not being taxed as earned income – it is the self stock and even though it only bested after certain years of employment or when you claimed it as income, the IRS would not let you include capital gains with the earned income exclusion.

FBAR

Direct ownership of stock does not have to be reported on the FBAR. For example, if Michelle on 10000 shares of XYZ Corporation stock, she would not need to report on the FBAR. But, if the stock is owned in an account and Michelle has an account number they typically the account number would be included on the FBAR — even if the stock is not identified individually.

When Michelle sold the stock for significant gain, the stock was placed into an account she has in the foreign country. The earnings were only in the account for a short period and then transferred to the United States. Nevertheless, if the account (or Michelle’s foreign accounts and aggregate total) exceeded $10,000 on any given day of the year she would still have to report the value of the account.

FATCA

Since Michelle resides overseas as a single person, she only has to report on form 8938 if she meets the threshold requirement. The threshold requirements for a single person or someone filing Married Filing Separately (MFS) is much higher for foreign residents than US residents.

For Foreign residents, a person has to file form 8938 if they have more than $200,000 in specified foreign assets on the last day of the year. Alternatively, if they have less than that amount on the last day of the year, but more than $300,000 on any other day the year, then they have to still report form 8938.

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Golding & Golding specializes exclusively in international tax, and specifically IRS offshore disclosure. 

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