Do You File an 83(b) Election for ISOs?
While an 83(b) election is key for some equity, its role with ISOs is often misunderstood. Learn the specific tax treatment and why it differs.
Equity compensation from an employer introduces new financial and tax considerations. Incentive Stock Options (ISOs) are a form of employee equity with specific tax advantages. Separately, an 83(b) election is an Internal Revenue Service (IRS) provision that alters the timing of tax liability on certain property received for services. The relationship between ISOs and the 83(b) election is a frequent source of confusion.
Understanding Incentive Stock Options
Incentive Stock Options give an employee the right to purchase company stock at a predetermined strike price. The first stage is the grant date, when the company gives you the options, and no income is reported. The next event is the exercise, when you purchase the shares. For regular income tax purposes, exercising an ISO is a non-taxable event.
The exercise can, however, trigger the Alternative Minimum Tax (AMT). When you exercise ISOs and hold the shares past the end of the calendar year, the difference between the stock’s FMV at exercise and your strike price—the bargain element—is an income item for AMT purposes, which can trigger a liability.
The final stage is the sale of the stock. A “qualifying disposition” receives the most favorable tax treatment. This requires selling the shares more than two years after the grant date and more than one year after the exercise date. If met, the entire gain is taxed as a long-term capital gain.
A “disqualifying disposition” occurs if you fail to meet both holding period requirements. In this case, the bargain element at exercise is treated as compensation income, and any additional appreciation is treated as a capital gain.
The Purpose of an 83(b) Election
The 83(b) election allows a recipient of property subject to a substantial risk of forfeiture, like vesting, to choose when to recognize income. It is most common with restricted stock awards (RSAs), where shares become fully owned after a vesting period. Without this election, an employee recognizes ordinary income on the value of the shares as they vest.
Filing an 83(b) election accelerates the tax event to the grant date. The motivation is the belief that the property’s value will increase, as paying tax on a low value at grant means future appreciation is treated as a capital gain upon sale.
For example, if you receive an RSA for 10,000 shares valued at $0.10 per share and file an 83(b) election, you recognize $1,000 of ordinary income immediately. If the stock appreciates to $20 per share by vesting, you owe no additional tax. Without the election, you would recognize ordinary income on the full $200,000 value as the shares vest. The risk is that if you forfeit the shares, you cannot recover the taxes paid.
The Interaction Between ISOs and the 83(b) Election
For a standard exercise of vested ISOs, you do not file an 83(b) election because the shares are not subject to a risk of forfeiture. The election only applies to unvested property.
The situation changes with the early exercise of ISOs, an option some private companies offer. Early exercise allows employees to purchase their optioned shares before they have vested, meaning you receive shares that are still subject to the original vesting schedule. These shares carry a “substantial risk of forfeiture,” making them restricted stock.
This is the specific scenario where an 83(b) election is relevant for ISOs. By filing an 83(b) election within 30 days of the early exercise, you recognize the bargain element for Alternative Minimum Tax (AMT) purposes that year. This can prevent a larger AMT adjustment later when the shares vest at a higher value.
Making an 83(b) Election for Other Equity Types
An 83(b) election is also a tool for other equity compensation, most commonly Restricted Stock Awards (RSAs). Another scenario involves Non-Qualified Stock Options (NSOs). Unlike ISOs, NSOs create a taxable event at exercise, where the bargain element is taxed as ordinary income.
Some companies permit the early exercise of unvested NSOs, which means you are purchasing restricted stock. This makes an 83(b) election relevant. By filing the election within 30 days, you can be taxed on the bargain element at that time. If the fair market value equals the strike price, the immediate tax could be zero, allowing subsequent appreciation to be treated as a capital gain.
How to File an 83(b) Election
If an 83(b) election is appropriate, the filing process has a strict deadline. The election must be filed with the IRS within 30 days of the property’s transfer date—the grant date for an RSA or the early exercise date for an option. You must draft a letter, as there is no official IRS form.
The letter must include:
- Your name, address, and Taxpayer Identification Number (TIN)
- A description of the property for which the election is being made
- The date of the transfer and the tax year
- The nature of any restrictions on the property, such as a vesting schedule
- Its fair market value at the time of transfer
- Any amount you paid for it
Mail the letter to the IRS service center where you file your annual tax return. Using Certified Mail with a return receipt is recommended for proof of timely filing. You must also provide a copy of the election to your employer and attach a copy to your federal income tax return for that year.