Do you have stock options? Are you about to receive a grant? Are you negotiating for a new job position and they are offering stock options? Then this article is for you.
I have written about stock options before and the pros and cons about retaining them or cashing them in. Boil it all down, and it’s basically up to you and whether you want to go ahead and grab the cash when it’s available or hold on and speculate on getting better value at the risk of losing existing value. There is no “right” or “wrong” in that. It’s really whatever you’re comfortable with.
But when it comes to taxes, there are different options to your options, that you probably have never heard of. And TurboTax probably wouldn’t help you here. This is one of those, if you don’t know about, you don’t know about it.
If you receive any form of stock or a stock option, there is the “default” way that the IRS views your situation and will tax you. Basically, as your stock vests, i.e. becomes available to you over some periodic schedule like four years, you can buy-and-sell immediately, and collect your profit. The IRS will view every nickel of profit as ordinary income and apply regular taxes. If your stock options vest over a four year period, and your company grows at a tremendous amount each year, your tax bill each year will go up, Up, UP. Yuck!
If you file an 83(b) exception at the time you initially receive the grant (but way before anything vests) you instead get to pay ordinary income taxes on the value at the time of issuance, and then later on, you only pay long term capital gains on the growth of the company’s value. The difference between a 28% and a 15% tax on your profits can become significant.
Let’s look at an example. Your company issues you 10,000 shares with a strike price of $1.00/share. Assuming it becomes available to you four years later, you have the option to buy the lot of stock for $10,000. The idea is that maybe your company goes public and the stock price if $20/share. You plunk down $10,000 and then sell the lot for $200,000, leaving you with a tasty profit of $190,000. And Uncle Sam will have his hand out, asking for $53,200(28%rate)
What does it look like if we file an 83(b)? First of all, you pay up front, within thirty days of issuance, $2800 in taxes. This is based on a 28% tax rate. From here on, any profit you glean will be based on long term capital gains. The same four years pass by, and ta-dah! The company is trading at the same $20/share. You buy-and-sell, and pocket $190,000. Only this time, you only have to pay Uncle Sam $28,500, being a long term capital gain. That totals $31,300, which is a $21,900 savings.
Maybe you’re a founder, and are actually getting issued 100,000 shares for a strike price of $0.01. Again, if you IPO four years later at $20/share, and never filed that 83(b), you would owe $559,720 in taxes. If you had filed that special 83(b) in the beginning, you would instead pay $280 up front in taxes, and four years later, a hair underneath $300,000. That is $260,000 in reduced taxes!
What risks are there in filing an 83(b). The risk is tied with the chance that your company doesn’t take off or ever acquired or IPO. In the first scenario, the amount of money on the line is $2800. In the second scenario, $280 is on the line. If you never cash in, you never get to harvest the incredible tax savings. So the question is, would you spend $2800 up front to save $21,900 later on in taxes? Or would you pony up $280 to save $260,000? Usually (99% chance anyone?) the answer is a resounding “yes!!!!!”
So why do you think the IRS has such a narrow window to get this? Because it’s almost always better to file the form and get your big tax deduction at the end.
I mentioned “the road not travelled” in the title. That’s because when I received the three different stock option letters over the past three years, I didn’t know anything about this. I could have saved a lot of tax money. But if there’s another one, I’ll be ringing up my CPA as fast as possible.
P.S. There is an entirely different range of issues when you start discussing Alternative Minimum Tax and how it can be impacted by stock options. I chatted with my CPA for thirty minutes on the phone about 83(b) elections and AMT so I could understand all the ramifications. It pays to have a CPA that understands this stuff inside and out, and yet won’t push you into particular situations. Suffice it so say, he or she is probably NOT working at an H&R Block stand at Walmart. Mine is on the other side of this country. That’s how far I went to find the right person.