I’ve always had the belief that filing an 83(b) election alongside an early exercise of stock options is a must. But are there situations where not filing the 83(b) election makes more sense? Here, I’m setting out to challenge my long-held belief.
For this deep-dive into the 83(b) decision, I make a few assumptions. We’re working with nonqualified stock options (NSOs) where the grant price equals the FMV at grant (no funky discounts here). The early exercise is made when the grant price equals the FMV at exercise, so there's no exercise spread to be taxed. Do not apply the conclusions from this exercise to ISOs, wherever there is a grant price discount, or when there exists a spread (and therefore ordinary income) on the exercise.
The following six scenarios exhaust the different price sequence possibilities, with the exception of cases where prices stay the same between two or more of the measurement points.
|Scenario||Grant Price = FMV at Exercise||FMV at Vest||Sale Price||83(b) Capital Gain (Loss) at Sale||No 83(b) OI at Vesting||No 83(b) Capital Gain (Loss) at Sale|
Description of the scenarios:
Scenario 1: Price rises from exercise to vesting, and rises again until sale
Scenario 2: Price rises from exercise to vesting, but falls below the exercise price at sale
Scenario 3: Price falls from exercise to vesting, but rises above the exercise price at sale
Scenario 4: Price falls from exercise to vesting, and continues to fall until sale
Scenario 5: Price rises from exercise to vesting, but falls until sale (such that the sale price is between the exercise price and the price at vesting)
Scenario 6: Price falls from exercise to vesting, but rises until sale (such that the sale price is between the price at vesting and the exercise price)
Note that accounting for stock that has fallen to $0 (worthless securities) is slightly different from accounting for stock that is sold at a loss, but is effectively the same for the purposes of this exploration.
- There are three possible tax statuses for filing vs. not filing the 83(b) election: long-term/long-term, long-term/short-term, or short-term/short-term. Short-term/long-term isn’t possible since the 83(b) election starts the holding period clock, therefore filing will never result in a shorter holding period compared to not filing.
- Since filing the 83(b) election starts the holding period clock for long-term capital gains purposes while not filing means the holding period starts at vesting, filing the 83(b) election increases the likelihood that a future sale will meet the holding period requirement for long-term capital gains.
- The amount of capital gain (loss) realized at sale when the 83(b) election is filed is the same amount as the sum of the ordinary income recognized at vesting and the capital gain (loss) realized at sale when the 83(b) election is not filed.
- Situations where the FMV at vesting is lower than the FMV at exercise result in no tax deduction when the shares vest.
Aside from some pretty unique situations, in general…
- The more ordinary income you can shift to capital gains, the better.
- Long-term capital gains are better than short-term capital gains.
- A capital gain is better than an equal amount of ordinary income and capital gain (loss) (assuming gains or losses have the same holding period status).
- Short-term capital losses are better than long-term capital losses, but the up-front investment decision shouldn’t be made with the expectation of losing money.
- Paying taxes later is better than paying taxes earlier.
- A situation where splitting the recognition of ordinary income and a future capital gain into separate tax years reduces the overall tax burden compared to realizing only capital gains at sale. For example, if the ordinary income is recognized in a low-income year and the capital gain is realized in a high-income year, or if splitting the ordinary income and capital gain avoids a higher marginal tax bracket.
- A capital loss situation (scenarios 4 and 6) where the holding period difference results in a long-term loss with the 83(b) election but a short-term loss without the 83(b) election.
- It’s conceivable that taxes on ordinary income may be lower than taxes on short-term capital gains even in the same tax year, once all taxes are taken into account (particularly the net investment income tax, or NIIT).
Unless you’re expecting to sell your shares at a loss, expect that your shares will vest in an unusually low-income year, or are confident in marginal tax savings due to NIIT, there’s little benefit to not filing the 83(b) election after early-exercising NSOs when there’s no spread between the grant price and the FMV at exercise.
Addressing the first situation, it wouldn’t make sense to exercise the shares at all if you have the expectation of a loss. The second situation would require a considerable amount of foresight and confidence in the benefit that not filing the 83(b) election would have. And my guess is that the risk of the decision turning out poorly (sacrificing long-term capital gains status, for example) would outweigh the potential benefit of perfect tax timing - there are a lot of variables out of your control. Lastly, NIIT is an additional 3.8% tax for certain investment income, which can result in higher taxes on short-term gains compared to ordinary income (assuming the ordinary income is above the Social Security wage base). Again, this requires a good amount of foresight and confidence, and the potential difference is probably not worth the risk - 3.8% NIIT on capital gains compared to 1.45% Medicare tax and 0.9% additional Medicare tax (if it applies to you) for earnings.
For an early exercise of NSOs with no spread between the FMV at exercise and the grant price (in other words, no tax on the exercise), I can barely even imagine a scenario where I would recommend against filing an 83(b) election. Sure, after the final sale occurs and a comparison can be done between filing vs. not filing the 83(b) election, it’s possible that not filing would have turned out better from a financial perspective. However, we must make sound decisions based on the information we have today. If you'd like any help evaluating your early exercise and 83(b) filing decisions, feel free to send me an email or schedule a time to talk.