When to choose the 83(b) election.

An 83(b) election allows one to recognize income on the purchase of stock (either outright or through the early exercise of an option) prior to the actual vesting of the stock. If you expect the value of the stock to rise significantly, it may make sense to pay income tax before it rises. This technique is often used by holders of private stock prior to an IPO, but it can also be used where there is a public market for the underlying security. Can it make sense for holders of a restricted stock grant?

For example, if you received a restricted stock grant at $50 per share and it didn't vest until the shares were trading at $70, you would be subject to income tax on the $70 price. However, if you used the 83(b) election to pay income tax on the $50 share grant up front, you could establish a cost basis at $50. If you then sold the stock upon its vesting date, assuming at least 12 months have passed, the $20 gain would be taxed as a long-term capital gain.

We used our WFS to determine whether it makes sense for an executive to make the 83(b) election up front for a $100,000 stock grant that vests in equal amounts over the next four years. We compared the result at the end of four years using two strategies: one in which the executive holds the stock and sells it at the end of four years, versus selling one-fourth of the stock at each vesting date. (36) The display (right) shows the results.

Both 83(b) strategies actually resulted in a lower median and downside value. The strategy is risky: If the stock price falls, you have in effect paid a higher tax than necessary, sooner than necessary.

83(b) and Stock Options

What about using the 83(b) election with stock options? (37) If you purchased a stock through the early exercise of an option (i.e., one allowed before vesting) that had an exercise price of $50 and the stock is at $50, and you applied the election, you would have no income tax due because the difference between the purchase price and the stock price is zero. Again, a basis would be established and any shares sold in the future would be capital gains.

If you exercised the option when the stock was $60, you paid income tax on the $10 profit and $50 for the stock. Your basis would be $60. But...