83(b) Elections: The Most Important Tax Decision

When you receive equity that is subject to vesting, Section 83 of the Internal Revenue Code determines when you recognize taxable income. By default, you are taxed when the equity vests, not when you receive it. An 83(b) election changes this and can save you enormous amounts of tax.

What Is an 83(b) Election?

An 83(b) election is a written statement you file with the IRS within 30 days of receiving restricted stock or other property subject to vesting. By filing, you elect to be taxed on the fair market value of the property at the time of grant, rather than at the time of vesting.

Why 83(b) Elections Matter

Consider this example: You receive 10% of a startup worth $100,000 today, vesting over 4 years. Without an 83(b), if the company is worth $10 million when your stock vests, you owe ordinary income tax on $1 million of "income" you never actually received in cash.

83(b) Election Math

Without 83(b): Taxed on $1M at vesting (ordinary income rates up to 37%)

With 83(b): Taxed on $10K at grant (ordinary income), then long-term capital gains on $990K when you sell

Potential savings: Over $150,000 in federal tax alone, plus you avoid the cash flow problem of owing tax on paper gains.

The 83(b) Election Timeline

Day 0: Equity Grant

You receive restricted stock or LLC interests subject to vesting. The 30-day clock starts NOW.

Days 1-25: Prepare and File

Complete IRS 83(b) election form. Mail to IRS Service Center via certified mail with return receipt. Keep a signed copy.

Day 30: ABSOLUTE DEADLINE

Election must be postmarked by this date. There are NO extensions, NO exceptions, NO excuses. Miss this and you cannot file.

April 15 (Next Year): Tax Return

Attach a copy of the 83(b) election to your personal tax return. Send a copy to the company as well.

TAX DISASTER: Missed 83(b) Deadline

The 30-day deadline is statutory and absolute. The IRS has no authority to grant extensions. Courts have consistently refused to allow late elections even when:

  • The taxpayer was unaware of the requirement
  • The company failed to inform the employee
  • The taxpayer was out of the country
  • The mail was delayed or lost

If you miss this deadline, you will owe tax on potentially millions of dollars of paper gains.

How to File an 83(b) Election

  1. Prepare the election: Include your name, address, SSN, description of property, date transferred, fair market value, amount paid, and a statement that you are making the election under Section 83(b)
  2. Sign the election: Both you and your spouse (if applicable) must sign
  3. Mail to IRS: Send via certified mail, return receipt requested, to the IRS Service Center where you file your tax return
  4. Keep proof: Retain the certified mail receipt, return receipt, and a copy of the signed election forever
  5. Notify the company: Provide a copy to the issuing company
  6. Attach to tax return: Include a copy with your next annual tax return

When NOT to File 83(b)

An 83(b) election is not always beneficial:

  • High current value, uncertain future: If the stock is already valuable and might decrease, you could pay tax on value you never receive
  • Likely forfeiture: If you might not stay for vesting, you pay tax on stock you never keep (and get no deduction for the loss)
  • No vesting restrictions: If your equity is not subject to vesting or forfeiture, 83(b) does not apply
  • Stock options: 83(b) elections generally do not apply to stock options; they apply when you exercise and receive restricted stock

Option Grant Timing and Tax Consequences

Stock options are a common form of equity compensation, but their tax treatment depends critically on when and how they are granted and exercised.

ISO vs. NSO: Two Different Tax Worlds

Feature Incentive Stock Options (ISO) Non-Qualified Stock Options (NSO)
Who can receive Employees only Anyone: employees, contractors, advisors
Tax at grant None None
Tax at exercise None (but AMT may apply) Ordinary income on spread
Tax at sale Capital gains (if holding period met) Capital gains on appreciation after exercise
Holding period 2 years from grant, 1 year from exercise 1 year from exercise for long-term gains

The Strike Price Problem

Options must be granted with an exercise price (strike price) at or above fair market value on the grant date. If the strike price is set too low, the IRS treats the difference as taxable compensation at the time of grant.

TAX DISASTER: Incorrect Strike Price

If options are granted with a strike price below fair market value (called "cheap stock"):

  • The bargain element is taxed as ordinary income at vesting (for NSOs) or exercise (for ISOs)
  • Section 409A penalties may apply: 20% additional tax plus interest from the vesting date
  • The company may face IRS scrutiny and accounting restatements
  • This commonly happens when early-stage companies undervalue their stock

Solution: Get a 409A valuation from a qualified firm before granting any options.

Exercise Timing Strategies

When you exercise options matters for tax purposes:

  • Early exercise: Exercise before vesting (if permitted), file 83(b), start capital gains clock early
  • Exercise and hold: Exercise but do not sell; risk of AMT for ISOs, ordinary income for NSOs
  • Same-day sale: Exercise and immediately sell; simplest but no capital gains treatment
  • Cashless exercise: Broker fronts the exercise cost from sale proceeds

LLC Allocation Mechanics

When you receive equity in an LLC rather than a corporation, the tax treatment follows partnership tax rules, which are fundamentally different from corporate stock.

Capital Interests vs. Profits Interests

LLCs can issue two types of equity interests:

  • Capital Interest: Entitles you to a share of the LLC's existing assets if the company were liquidated today. Receiving a capital interest for services is taxable as ordinary income equal to the value of your share.
  • Profits Interest: Entitles you only to a share of future profits and appreciation, with no right to existing value. If structured correctly, profits interests can be received tax-free.

Why Profits Interests Are Popular

A properly structured profits interest allows you to receive equity compensation in an LLC without any immediate tax liability. You are only taxed when the LLC earns profits or when you sell your interest. This is similar in effect to an 83(b) election but without having to actually pay tax at grant.

K-1 Tax Reporting

As an LLC member, you receive a Schedule K-1 each year showing your share of the LLC's income, deductions, and credits. You must report this on your personal tax return even if you did not receive any cash distributions.

Phantom Income Warning

LLC members can be taxed on their share of profits even if no cash is distributed. This creates "phantom income" where you owe tax but have not received cash to pay it. Your operating agreement should address minimum tax distributions to prevent this situation.

Self-Employment Tax Issues

Unlike corporate stock, LLC interests may trigger self-employment tax if you are actively involved in the business. General partners and active LLC members may owe an additional 15.3% in self-employment taxes on their share of ordinary income.

Profits Interest Tax Treatment

Profits interests have become the preferred equity compensation vehicle for LLCs, but they must be properly structured to achieve tax-free treatment.

Requirements for Tax-Free Grant

Under IRS Revenue Procedure 93-27 and 2001-43, a profits interest can be received tax-free if:

  1. It is granted for services to or for the benefit of the partnership
  2. The recipient would receive nothing if the partnership liquidated immediately after the grant
  3. It is not related to a substantially certain and predictable stream of income
  4. The recipient is not entitled to a guaranteed payment
  5. The interest is not disposed of within 2 years

The Liquidation Value Hurdle

The key concept is that a profits interest holder must have a "hurdle" or "threshold" equal to the current liquidation value of the LLC. They only share in value above this threshold.

Example: Profits Interest Hurdle

LLC is worth $1 million today. You receive a 10% profits interest with a $1 million hurdle. If the LLC is sold for $3 million:

  • Amount above hurdle: $3M - $1M = $2 million
  • Your share: 10% of $2 million = $200,000
  • Taxed as capital gains if held more than 1 year

Vesting and 83(b) for Profits Interests

Even though the grant of a profits interest is tax-free, if the interest is subject to vesting, you should still file an 83(b) election. This ensures that future appreciation is taxed as capital gains rather than ordinary income when the interest vests.

Safe Harbor Requirements

To ensure profits interest treatment, the LLC operating agreement should be updated to reflect the grant, and the recipient should be treated as a partner from the grant date. Failure to meet the safe harbor requirements could result in taxable income at grant.

Common Tax Traps to Avoid

Trap #1: Forgetting the 83(b) Deadline

Set multiple calendar reminders. Send by certified mail on day 1. The 30-day deadline has destroyed more wealth than any other tax rule in equity compensation.

Trap #2: ISO Alternative Minimum Tax

Exercising ISOs triggers AMT on the spread, even though you do not owe regular income tax. Many people have faced six-figure AMT bills from exercising options in stock they could not sell.

Trap #3: Section 409A Violations

Deferred compensation rules apply to many equity arrangements. Options with below-market strike prices, extended exercise periods, or modified terms can trigger 20% penalty taxes plus interest.

Trap #4: Founder Stock Without Vesting

If you receive founder stock without vesting restrictions, you cannot file an 83(b) election and may miss out on tax benefits. Consider imposing vesting even on founder shares.

Trap #5: Contractor Classification Issues

If the IRS reclassifies you as an employee rather than a contractor, your equity compensation may be recharacterized, and both you and the company face back taxes and penalties.

Questions to Ask Your CPA

Before accepting equity compensation, discuss these questions with a tax professional:

Essential Questions

  1. Should I file an 83(b) election, and what is the deadline?
  2. What is the fair market value of the equity I am receiving?
  3. Will I owe any tax at the time I receive this equity?
  4. What are the tax consequences when my equity vests?
  5. Am I receiving a capital interest or profits interest in this LLC?
  6. Will I receive K-1s and owe tax on undistributed income?
  7. Does the operating agreement provide for tax distributions?
  8. Are these ISOs or NSOs, and what are the AMT implications?
  9. What is the strike price, and is it supported by a 409A valuation?
  10. What happens to my tax situation if I leave before fully vested?
  11. How will self-employment tax apply to my LLC interest?
  12. What are the holding period requirements for capital gains treatment?

Get Professional Help

Equity compensation tax is complex and the stakes are high. A single missed deadline or incorrect election can result in tax bills exceeding the value of the equity you received. Invest in a qualified tax professional before accepting any equity-for-services arrangement.