Exercising Options and Deferring Taxes with the 83(i) Election
January 24, 2020 | Stanley K. Himeno-Okamoto, CFA, CFP®
The 83(i) election was introduced with the Tax Cuts and Jobs Act of 2017 to help employees of private companies exercise their stock options by deferring the inclusion of the exercise’s “bargain element” income and thus their tax liability at exercise by up to five years. When the difference between the fair market value of the equity at the time of exercise and the exercise cost is substantial (the bargain element), the tax liability could be prohibitively high - to the extent that options can never be exercised because of the tax burden and they subsequently expire.
When exercising options and considering making an 83(i) election on some or all of your shares, you’ll either have enough money to pay the tax liability now or not have enough. Whichever one applies to you, if there’s one thing you take away from this, it’s to have a plan in place. Trying to build a startup without a plan is a surefire way to crash and burn, which is why you and your company probably have a business plan, targets, and contingencies. The same should apply to your personal financial life. A well-thought-out plan doesn’t mean everything will go smoothly, but it will help you take setbacks in stride and know what to do when things aren’t playing out how you had hoped.
So you want to exercise your options but you don’t have the money to pay the tax liability now. Treat your future tax liability like a loan that will be due all at once in the future. The tough part is knowing the when – your company could get acquired in one year or have its IPO in four. Once you’ve decided on a time frame (shorter if you expect an earlier exit or want less risk of not being ready to pay the tax bill; longer if you expect a later exit or are willing to accept more risk of an accelerated due date), make periodic – monthly or every pay period – contributions to an account specifically for your future tax bill. I’d typically suggest a high-yield savings account or a brokerage account invested in lower-risk fixed income products.
Know and understand your options in case an exit comes sooner than expected and is unsuccessful. Do you have a HELOC to tap into that you can pay back over time? Are your taxable accounts large enough for a securities-backed line of credit to cover the taxes? How much could a poor, early exit affect your financial situation?
Don’t make an 83(i) election without a plan to raise the money to pay the taxes. Very promising companies over the last several years have had spectacular meltdowns or simply fizzled out; there’s no guarantee that your company will have a successful exit, no matter how hot it is today.
By not planning, you put yourself at risk of not being able to pay the tax liability when it eventually comes due. Maybe even more importantly, stress about future taxes due and your company’s seemingly perpetual illiquidity might start to grow – taking away the sleep-at-night factor we try to provide our clients. Even if everything works out in the end, would the extra stress and anxiety be worth it?
What if you have the money to exercise and pay the taxes? You have a solid financial foundation but for any number of reasons, you want to defer the taxes. I would still highly recommend planning it all out. You’d probably be okay without planning since you have a financial buffer, but if things don’t work out, you’ll be kicking yourself, asking, “should I have done something differently?” At the end of the day, financial planning isn’t just about money. Peace of mind and eliminating financial anxiety is arguably far more important.
Most situations are covered by the above, but here are some of the most common situations we’ve come across:
You have ISOs to exercise.
- 83(i) elections can’t be used for ISO exercises – they convert to NSOs. Therefore, you lose all tax benefits of your ISOs if you exercise them with an 83(i) election.
- Unless you have a really good reason why you need to exercise ISOs and make an 83(i) election, don’t do it. Consult with your financial planner or CPA to understand your unique situation and determine if it could make sense to make the election anyway.
You recently left your company and you have 90 days to exercise your options or they expire, or you’re still at your company but your options expire soon if you don’t exercise them.
- You should have a plan in place to understand the right number of options to exercise. There’s no rule that says you have to exercise all or none. Don’t use 83(i) to blindly exercise everything and figure it out later.
- Understand the landscape of the private secondary market for your company’s stock. If a market exists, this could allow you to exercise more and pay the taxes using proceeds in a private secondary sale. A deal is never certain, and this uncertainty adds some risk.
The above situation, but you have ISOs.
- If you’re going to lose them without the election, it could make sense to convert ISOs to NSOs in order to avoid losing out on all of your equity. However, you will lose all tax advantages ISOs provide.
- Work with your CPA to find out how many ISOs you can exercise without triggering substantial AMT. If you won’t be subject to AMT on some of the shares exercised, an 83(i) election on that number of shares would offer no benefit.
You plan on exercising your options near the end of the year and just want to push the tax liability out by a year.
- Stick to your strategy – don’t go into it with a plan to defer for one year and end up deferring for as long as possible. Revoke the election in the next tax year.
- You wouldn’t exercise a different number of options this year vs. next year, but you might push an exercise out by a couple of months if 83(i) didn’t exist, so here the 83(i) election just allows you to exercise near the end of a tax year instead of pushing an exercise out a couple of months in order to get an extra year before paying the taxes.
- I’d typically suggest holding the money for the future tax bill in a high-yield savings account, or very short-term, low risk fixed income products. You can get a bit of yield with a lower risk of principal loss.
You’ve owned 1% or more of the company at any point in the last 10 years, you’re one of the top four highest compensated officers in the last 10 years, you’re the current or former CEO or CFO, or you’re a “related party” to a current or former CEO or CFO (318(a)(1)).
- You’re an “excluded employee” and are not allowed to make 83(i) elections on that company’s stock.
- Becoming an excluded employee after making an 83(i) election triggers the inclusion of the deferred income and the resulting tax liability in the current tax year.
- If there’s a real possibility of becoming an excluded employee in the next five years, you’ll have to make a judgment on the risk of having the taxes due on an exercised accelerated.
Individual states' adoption of 83(i):
The 83(i) election is built into the federal tax code, and your state may or may not adopt the election into its tax code. For example, California typically doesn’t conform to the federal tax code, and it’s still uncertain how they will address 83(i). As of now, the safest bet is to assume there is no deferral for California state taxes, but this may change as more taxpayers make the 83(i) election and ask the FTB for guidance.
Mandatory withholding rules:
Withholding of 37% of the deferred income amount is required. Since that effectively defeats the purpose of the 83(i) election, especially for those who wouldn’t be able to exercise without the election (if you can’t pay the taxes next April, you probably can’t afford to have a 37% withholding today), the IRS has a mandated escrow arrangement that forces the stock affected by the 83(i) election to be held in escrow until the 37% withholding requirement is met.
No matter what your situation, if you’re thinking about making an 83(i) election when exercising stock options, consult with a CPA and financial planner to make sure you’re making the right decision. If you want to talk about your stock options and equity grants, feel free to send me an email or schedule a time to talk.
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