83(b) Elections and Stock Options: When It Applies and When It Does Not
Anita Smith
Director of Operations
Founders and early employees frequently confuse when 83(b) elections apply to stock options versus restricted stock. Getting this wrong can be very expensive.
The Basic Rule: 83(b) Requires Property Transfer
IRC Section 83(b) allows a taxpayer to recognize income at the time of receiving property rather than when restrictions lapse. The critical word is property. Stock options are not property. They are a contractual right to purchase property in the future. You cannot file an 83(b) election on an option grant. The election only becomes relevant when you actually own shares that are subject to a substantial risk of forfeiture, meaning they can be taken back if you leave or fail to meet certain conditions. This distinction trips up many first-time founders who receive an option grant and are told they need to file an 83(b) within 30 days.
Restricted Stock Awards (RSAs) vs Stock Options
Restricted stock awards give you actual shares on the grant date, but those shares are subject to vesting. Because you own the shares from day one, 83(b) applies. You can elect to recognize income on the grant date when the value is low. Stock options, by contrast, give you the right to buy shares later at a predetermined price (the exercise price). Since you do not own shares until you exercise, there is nothing for 83(b) to attach to at the time of the grant. Founders typically receive restricted stock at incorporation for a nominal price. Employees typically receive stock options after the company has a higher valuation.
Early Exercise Options: Where the Overlap Occurs
Some companies allow employees to early exercise their stock options, meaning they can purchase the underlying shares before the options vest. When you early exercise, you receive shares that are subject to a vesting-based repurchase right, which is a substantial risk of forfeiture. At that point, the 83(b) election becomes available and critically important. If you early exercise 50,000 options at $0.10 per share when the FMV is $0.10, filing the 83(b) means your ordinary income is zero ($0.10 - $0.10 = $0 per share). Without the election, you would recognize ordinary income on each vesting tranche at whatever the FMV is at that time.
ISOs and the 83(b) Election
Incentive stock options (ISOs) have special tax treatment under IRC Section 422. When you exercise an ISO and hold the shares, there is no regular income tax, but the spread is an AMT preference item. If you early exercise an ISO and file an 83(b), the AMT calculation is based on the spread at exercise, which is zero if you exercise at fair market value. This eliminates the AMT issue entirely for early-exercised ISOs. However, the 83(b) election also means the shares are treated as having been transferred to you on the exercise date for purposes of the ISO holding period requirements. You must hold for at least two years from the option grant date and one year from the exercise date to get ISO tax treatment on the eventual sale.
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