What is 183(b) Election

This is a tax election that allows startups business owners to pay tax on the total fair market value of vested shares. When shares are subjected to vesting, it means that at every time a portion of the share is vested upon, the Internal Revenue Service would treat it as a taxable event. This situation can lead to a significant increase in the tax paid as the Fixed Market Value of the vested stock increase.

Usually, the tax is calculated in the form of an illiquid stock which could be more than what the owner can pay. Added to this, the number of times the FMV would be processed could be a burdensome process. For instance, the FMV of 2 years straight vesting would be determined 24 times. As the years of vesting increase, the number of times FVM would be determined also increases.

Fortunately, the IRS permits owners of restricted stocks to elect alternative tax using the 83(b) election. This allows stock owners to prepay low tax liability. However, if the value of stock declines continuously, the owner would overpay in tax by prepaying on higher equity valuation.

Understanding the 183(b) Election

Assuming a cofounder of a company is given a one million share of 5-year-straight vested stocks representing his 10% ownership of the company. The initial tax rate is $0.001 as at the timeshares were given to him. The par value of the share would be $0.001 × the number of shares. This would give us $1000. The initial tax liability would be $1000. The expected amount the cofounder would be receiving every year for the period of five years is $200,000. Now, for each year, he would be required to pay the fair market value of the income he is receiving from the share.

Now if in the first year, the company's equity value increased to $100,000. The 10% ownership right of the cofounder would increase from $1,000 to $10,000. The calculation for his tax liability for the first year would be (100,000 - $10,000) x 10% x 20% = $1,800. Here, 20% stands for the five-year vesting period.

If in the second year, the value of stock increases significantly to $500,000, the expected tax liability would be  ($500,000 - $10,000) x 10% x 20% = $9,800. If the stock should increase the next year and subsequent years until vesting elapses, the tax liability rate increase.

When the co-founder sells the shares after five years, his entire proceed would be subjected to a capital gain tax.

With the 183(b) election, the cofounder can pay just the initial $1,800 tax which is the lowest tax liability. He won't pay additional tax in subsequent years whether the shares increase or not. This kind of election is very beneficial when the share is certain to increase. However, if the price of share decreases in subsequent years, the cofounder loses.