83(B) vs ISOs

Arin V., EA , MBA

Arin is an Enrolled Agent (EA), authorized to represent taxpayers in front of the IRS, and holds a BA and MBA (Management) degree from California State University, Northridge.

To build upon last week’s article about the differences between stocks and options, today we shall explore incentive stock options (ISOs) in a little more detail, as well as elucidate on the 83(b) election. Indeed, this is not necessarily a topic that’s discussed at the water cooler every day, yet it is a very important topic, particularly if one holds shares in a startup company.

To recap from last week, statutory stock options, such as ISOs, are considered employee benefits that allow you to purchase the company’s stock at a discount on the market price. However, depending upon when you exercise the ISOs, you may be subject to the Alternative Minimum Tax (AMT). In addition, the difference between the exercise price and the market price is taxed at ordinary income tax rates. This scenario, of course, may lead to a large tax liability for the holder of those ISOs.

However, if your employer allows you to exercise the ISOs early, thus allowing you to buy the shares before they vest, you may be able to avoid some taxes when you buy, or exercise, rather, all your stock options. This requires one to make an 83(b) election.

When you make an 83(b) election, the fair market value (FMV) of the option is considered to be the same as the FMV on the grant date. In essence, in this scenario, if you were to make an 83(b) election, the IRS would treat these unvested shares as vested, and you would pay up front on the date of exercise, as opposed to the day when the shares vest. The thought process behind this maneuver is that if the stock is going rise in value over time, then buying the shares earlier will result in a lower tax liability. Also, it is important to note that in this scenario, the holding period of the stock would begin right after this early exercise. However, the risk with making an 83(b) election is that if the share price goes down over time instead of going up, you will have paid tax on a higher share price. Also, if you decide to leave the company before the shares vest, you would have paid tax on stock that you do not get to keep. 

To describe the 83(b) election with an example, assume that you work for a startup company, and the company has granted you 5,000 ISOs at a price of $5. If you are able to exercise these ISOs early when the FMV is still $5, you could make an 83(b) election. In this scenario, given that the FMV of the ISO is equal to the grant price of $5, you would have no taxable income to report from this transaction (since there would be no spread between the FMV and the exercise price). You would, however, have a cost of $25,000 up front in order to exercise the ISOs early. Supposing, however, that you did not exercise early, but instead, waited to vest 2,500 ISOs a year later, and in this scenario, that the FMV of the shares had increased to $20. You would then have a taxable income of $50,000. Of course, this would be the case each time you exercised the ISOs in the future – you would have taxable income for the difference between the FMW on the date of exercise minus the strike price. Therefore, in making an 83(b) election, you would be paying a little bit up front for the benefit of not having a large tax liability later.  

To make an 83(b) election, you will need to submit a statement to the IRS within 30 days of exercising your ISOs. Therefore, this is something you will need to do quickly, and, in the right manner. If you hold ISOs and are considering an 83(b) election, we recommend you reach out today to ensure things are done properly, so you can avoid a potentially large tax liability.