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What is a Section 83(b) election?

A person who purchases or otherwise receives shares of restricted stock (including unvested stock that is purchased through the early exercise of an option) is generally taxed when the shares vest, but he or she may instead choose to be immediately taxed by filing a Section 83(b) election with the IRS within 30 days after receiving the shares.

A Section 83(b) election causes the stock to be treated as vested on the date of transfer meaning:

  • The recipient of the restricted stock recognizes ordinary income equal to the excess if any, of the fair market value of the shares over the exercise or purchase price paid for the shares, if any (the spread) on the date of transfer
  • Your company is generally entitled to a deduction equal to the amount of ordinary income recognized by the recipient
  • The company has a withholding obligation for income and employment taxes based on the spread, if any, on the date of transfer, if the recipient is an employee
  • The recipient’s capital gain holding period begins at the time of the transfer
  • Any later increase in the value of the shares will not be taxed until the shares are sold and will be taxed as capital gain

The potential downside to making a Section 83(b) election is if the restricted stock does not vest and is forfeited or repurchased at cost by the company, the recipient will not receive a tax credit or a tax deduction for any taxes he or she already paid. From the company’s perspective, if the value of the stock increases after the election is made, the company has lost the benefit of a higher deduction.

For early-exercised incentive stock options, a Section 83(b) election is available only for alternative minimum tax purposes, and the election will not start the 12-month clock for long-term capital gain treatment. Please see the related article on the U.S. federal tax effects of early exercising an incentive stock option.

What is a Section 83(i) election? What does my company need to do with respect to Section 83(i) elections?

The Tax Cuts and Jobs Act of 2017 added a new Section 83(i) to the Internal Revenue Code, which may allow an eligible employee to defer federal income tax otherwise resulting from the acquisition of shares after December 31, 2017, through the exercise of a stock option or settlement of a restricted stock unit for up to five years by filing a Section 83(i) election with the IRS within 30 days after the date of exercise of an option (or for unvested shares purchased through the early exercise of an option, within 30 days after the date of vesting or the stock becoming transferable, whichever is earlier) or within 30 days after the date of settlement of a restricted stock unit, if the employee and the company satisfy certain eligibility requirements. The Section 83(i) election will not defer federal employment taxes and also may not defer state taxes in certain states.

If a stock option or restricted stock unit satisfies the eligibility requirements for a Section 83(i) deferral election, the company must provide notice of eligibility for the election generally when (or a reasonable period before) the shares covered by the option (or restricted stock units) would, but for the application of Section 83(i), be taxable to the employee. Generally, this is the date on which the company transfers the shares to the employee (or for unvested shares purchased through the early exercise of an option, the date of vesting if the employee does not timely file a Section 83(b) election with the IRS to treat the shares as vested on the date of transfer for tax purposes).

Please see WSGR’s client alert on Section 83(i) for more information.

What does a company need to do with respect to taxes on equity awards?

For an option (or restricted stock unit) held by an employee, if the eligibility requirements for a Section 83(i) deferral election are satisfied, the company must provide notice of eligibility for the election generally when (or a reasonable period before) the shares covered by the option (or restricted stock unit) would, but for the application of Section 83(i), be taxable to the employee. Generally, this is the date on which the company transfers the shares to the employee (or for unvested shares purchased through the early exercise of an option, the date of vesting if the employee does not timely file a Section 83(b) election with the IRS to treat the shares as vested on the date of transfer for tax purposes).

For U.S. federal tax purposes, your company must report any ordinary income recognized by a service provider in connection with stock options and restricted stock:

  • The exercise of a nonstatutory stock option (which is an option that is not eligible for favorable U.S. federal tax treatment), unless the optionee timely files a Section 83(i) election (if eligible) with the IRS to defer the federal income taxes ordinarily due upon exercise
  • The sale or transfer of shares acquired through the exercise of an incentive stock option (which is an option that is eligible for favorable U.S. federal tax treatment, if certain requirements are met) that does not meet the holding periods necessary to receive favorable U.S. federal tax treatment (which is referred to as a disqualifying disposition)
  • The purchase or award of restricted stock, which are shares of stock that typically are subject to forfeiture or repurchase if they do not meet vesting requirements, where a Section 83(b) election was timely filed with the IRS
  • The vesting of restricted stock for which a Section 83(b) election was not timely filed with the IRS

This income should be included on Form W-2 or Form 1099, depending on whether the service provider is an employee or not. For these tax purposes, outside directors are not treated as employees, even though they are treated as employees under the accounting rules.

If the service provider is an employee, the company will be required to withhold applicable income, employment and other taxes. Note that if a service provider was both an employee and a non employee, you should contact a member of our employee benefits and compensation practice or a member of your corporate practice to discuss this.

In addition, the company will have an annual reporting obligation in connection with the exercise of incentive stock options (ISOs). For each ISO exercised, the company must file a Form 3921 with the IRS and provide a copy to the optionee.

For state, local, and international tax purposes, additional or different requirements or consequences may apply.

What are the U.S. federal tax effects of nonstatutory stock options?

There generally are no U.S. federal taxes due when a nonstatutory stock option (NSO) is granted, unless the NSO is granted with an exercise price less than the fair market value of the underlying stock on the date of grant, which is called a discount option. When the NSO is exercised after it vests, the optionee generally is taxed at ordinary income tax rates on the excess, if any, of the fair market value of the shares over the exercise price paid for the shares (the spread) at exercise.

An employee optionee generally is subject to tax withholding (federal and state income and employment taxes, and sometimes local taxes) on this spread at exercise and the income must be reported to the taxing authorities, unless the employee optionee timely files a Section 83(i) election (if eligible) with the IRS to defer the federal income taxes ordinarily due upon exercise. A non-employee optionee generally is subject to tax reporting, but not withholding. The company should be entitled to a deduction equal to the amount of ordinary income recognized by the optionee.

If the shares purchased through such exercise of the option are later sold or otherwise transferred, any gain or loss recognized by the optionee upon the sale or transfer of the shares generally will be treated as capital gain or loss, and such gain or loss will be long term or short term depending on whether the optionee has held the shares for more than one year after exercise.

NSOs that are discount options may result in unfavorable tax consequences for optionees, including additional taxes and earlier taxation. As a result, at the time of grant, it is critical to determine the fair market value of stock underlying an option according to the guidance issued by the IRS.

Bear in mind that the U.S. federal tax consequences (See FAQ: "What are the U.S. federal tax effects of early exercising a nonstatutory stock option") of early exercising an NSO to purchase unvested shares will be different from the consequences of exercising an NSO for vested shares as described above.

What are the U.S. federal tax effects of early exercising a nonstatutory stock option?

When an optionee early exercises a nonstatutory stock option to purchase unvested shares, the optionee recognizes ordinary income when the shares vest in an amount equal to the excess, if any, of the fair market value of the shares over the exercise price paid for the shares (the spread), as of the vesting date, unless the optionee timely files a Section 83(b) election or Section 83(i) election (if eligible) with the IRS. The Section 83(b) election treats the unvested shares as vested on the date of transfer for tax purposes, whereas the Section 83(i) election defers the federal income taxes ordinarily due upon exercise for a period of up to five years.

If the shares are later sold or otherwise transferred, any gain or loss recognized by the optionee upon the sale or transfer of the shares generally will be treated as capital gain or loss, and such gain or loss will be long-term or short-term depending on whether the optionee has held the shares for more than one year after the shares vest.

If a Section 83(b) election is properly filed, the optionee instead recognizes ordinary income when the shares are received in an amount equal to the spread, if any, at the time the shares are received. If the shares are later sold or otherwise transferred, any gain or loss recognized by the optionee upon the sale or transfer of the shares generally will be treated as capital gain or loss, and such gain or loss will be long-term or short-term depending on whether the optionee has held the shares for more than one year after the shares were received.

The company is generally entitled to a deduction equal to the amount of ordinary income recognized by the optionee.

What are the U.S. federal tax effects of early exercising an incentive stock option?

An optionee generally does not recognize taxable income when he or she early exercises an incentive stock option (ISO), but the difference between the option exercise price and the fair market value of the purchased shares is an adjustment for alternative minimum tax (AMT) purposes. If the optionee does not sell or otherwise transfer the shares purchased through such exercise within two years after the date of grant or within one year after the date of exercise, then upon the sale or transfer of such shares, any gain will be treated as long-term capital gain (which is taxed more favorably than ordinary income).

However, if the optionee sells or transfers the shares before meeting both of the holding periods described above (a disqualifying disposition), generally the optionee will recognize ordinary income in an amount equal to the excess, if any, of the fair market value of the shares on the vesting date (or, if less, the amount realized on the sale or transfer of the shares) over the exercise price of such shares.

Any further gain or loss realized by the optionee will be taxed as short-term or long-term capital gain or loss, as the case may be. The 12-month clock for long-term capital gain treatment begins on the vesting date, and not the date of early exercise.

Please be aware that the early exercise of ISOs may affect the determination of an optionee’s AMT. When an optionee exercises an ISO, he or she will be required to include the amount equal to the excess, if any, of the fair market value of the shares over the exercise price paid for the shares (the spread), as of the vesting date as an adjustment item in the determination of his or her AMT, unless such person timely files a Section 83(b) election with the IRS. The election treats the restricted stock as vested on the date of transfer for tax purposes.

However, if the optionee sells or transfers the shares in the same calendar year as the date of exercise of the ISO, then no adjustment with respect to those shares is included in the determination of the optionee’s AMT.

If a Section 83(b) election is timely filed, the optionee’s AMT adjustment is based upon the spread at exercise. With respect to ISOs that are early exercised, a Section 83(b) election is available only for AMT purposes, and the election will not start the 12-month clock for long-term capital gain treatment. Determination of the AMT is complex and highly dependent on the optionee’s individual situation. As a result, optionees should consult with their tax advisers before early exercising any ISOs to understand the tax consequences of early exercising ISOs and the sale or transfer of shares.

What are the U.S. federal tax effects of incentive stock options?

There are no taxes due when an incentive stock option (ISO) is granted or exercised. If the stock is held for more than one year after the date of exercise of the ISO and more than two years after the date of grant of the ISO, any gain or loss upon the sale or transfer of the stock will be a long-term capital gain or loss.

An earlier sale or transfer generally will be a disqualifying disposition that results in ordinary income tax on the lesser of:

  • the excess, if any, of the fair market value of the shares over the exercise price paid for the shares (the spread) at exercise; or
  • the excess of the proceeds from the sale or transfer over the exercise price.

To the extent an optionee realizes ordinary income in connection with a disqualifying disposition, the company generally may take a corresponding deduction.

Please be aware that the exercise of ISOs may affect the determination of an optionee’s alternative minimum tax (AMT). When an optionee exercises an ISO, he or she will be required to include the amount equal to the spread at exercise as an adjustment item in the determination of his or her AMT. However, if the optionee sells or transfers the shares in the same calendar year as the date of exercise of the ISO, then no adjustment with respect to those shares is included in the determination of the optionee’s AMT.

Determination of the AMT is complex and highly dependent on the optionee’s individual situation. As a result, optionees should consult with their tax advisers before exercising any ISOs to understand the tax consequences of exercising ISOs and the sale or transfer of shares.

Please note that the U.S. federal tax consequences of a disqualifying disposition of shares acquired through the early exercise an ISO will be different from those described above.

If I grant early exercise options, should I grant the options as incentive stock options or nonstatutory stock options?

It depends. If the optionee will exercise the option immediately to purchase all of the shares covered by the option while they are unvested, the optionee will be better off with a nonstatutory stock option (NSO). In that case, the optionee can file a Section 83(b) election with the IRS. The election treats the unvested shares as vested on the date of transfer for tax purposes. There likely will be no difference between the exercise price and the fair market value on the date of exercise, and therefore the optionee will not have to pay any U.S. federal taxes. The optionee will need to hold the shares for more than one year to receive long-term capital gains treatment.

In contrast, an optionee who immediately exercises an incentive stock option (ISO) will not recognize any income in connection with such exercise, but the optionee will need to hold the shares for more than two years to meet both of the necessary holding periods and receive long-term capital gains treatment. If the optionee fails to do so, the optionee will recognize ordinary income equal to the excess, if any, of the fair market value of the shares over the exercise price paid for the shares at exercise.

With respect to ISOs that are early exercised, a Section 83(b) election is available only for purposes of the alternative minimum tax (AMT), and the election will affect the timing and amount of the optionee’s AMT adjustment, if any, in connection with the ISO exercise, but will not start the 12-month clock for long-term capital gain treatment. That 12-month clock begins on the vesting date, and not the date of early exercise. Since the vesting date is later than the date of early exercise, there is an increased likelihood that any capital gain on a disqualifying disposition will be short-term capital gain and taxed as ordinary income.

If the optionee meets the necessary holding periods for favorable U.S. federal tax treatment, then the full difference between the sale price and the exercise price is recognized as long-term capital gain, which is the same treatment the NSO holder would receive if he or she early exercised right after grant, when there was no spread between the exercise price and the value at exercise, and he or she had timely filed a Section 83(b) election. The only difference is that the NSO holder would have only had to have held the shares just over one year before selling, while the incentive stock option holder would have had to hold the shares more than two years from the grant to receive the same federal tax treatment.

What is an Employer Identification Number (EIN)?

An Employer Identification Number (EIN)—also known as a Federal Tax Identification Number—is used to identify a business entity. Generally, businesses need an EIN. Click here to view instructions on how to apply online for an EIN, and click here to apply online. In addition to the EIN, businesses must register with the tax authority in the state in which they are operating.

What are the U.S. federal tax effects of restricted stock?

A person who purchases or otherwise receives shares of restricted stock (including unvested stock that is purchased through the early exercise of an option) recognizes ordinary income when the shares vest in an amount equal to the excess, if any, of the fair market value of the shares over the purchase price paid for the shares, if any (the spread), as of the vesting date, unless such person timely files a Section 83(b) election with the IRS. This election treats the restricted stock as vested on the date of transfer for tax purposes.

If the shares are later sold or otherwise transferred, any gain or loss recognized by the recipient upon the sale or transfer of the shares generally will be treated as capital gain or loss, and such gain or loss will be long-term or short-term depending on whether the recipient has held the shares for more than one year after the shares vest.

If a Section 83(b) election is properly filed, the recipient of the restricted stock instead recognizes ordinary income when the shares are received in an amount equal to the spread, if any, at the time the shares are received. If the shares are later sold or otherwise transferred, any gain or loss recognized by the recipient of the restricted stock upon the sale or transfer of the shares generally will be treated as capital gain or loss, and such gain or loss will be long-term or short-term depending on whether the recipient has held the shares for more than one year after the shares were received.

The company will be entitled to a deduction equal to the amount of ordinary income recognized by the recipient of the restricted stock at the end of the recipient’s taxable year in which the recipient recognized such income.

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