83(b) election and early exercise: A guide for early employees

Founders and early startup employees often receive large equity grants in exchange for their work building a company. These grants, while potentially lucrative, come with complicated tax implications that can catch you off guard if you're unprepared.

What is an 83(b) election?

The 83(b) election is a provision in the tax code that lets you opt to pay taxes on startup equity when it's granted, usually when it's worth very little, rather than when it vests. Filing an 83(b) locks in that low value for tax purposes. Later, if you sell the shares after meeting holding requirements, profits may qualify for long-term capital gains treatment, typically at a lower tax rate than ordinary income. Essentially, by filing an 83(b) election, you can freeze the taxable value at the grant date.

What is early exercise?

Early exercise allows you to buy stock options — typically incentive stock options (ISOs) — before they vest. Not all companies allow this, but it's becoming more common among startups looking to offer tax-advantaged compensation.

Here's how it works:

• You pay the strike price to purchase the shares, even though they'll vest over time.
• The shares are still subject to the vesting schedule, meaning if you leave the company early, you could lose the shares.
• If you file an 83(b) election within 30 days of the early exercise, the IRS treats the shares as though you received them right away, not later when they've vested.

This timing matters. Filing the 83(b) starts the clock on long-term capital gains treatment. Without the election, you could end up owing greater tax in the future if you exercise your shares once the value of the stock has appreciated.

83(b) election and early exercise: An example

An employee is granted 100,000 shares. At the time of the grant, the shares are worth just $0.10 each, meaning they can buy all their shares for $10,000. Years later, the company's value has risen to $10 a share, making the shares worth $1 million.

With the 83(b)

The employee decides to early exercise and files an 83(b) election within 30 days. They pay $10,000 to buy all 1 million shares. Because the fair market value of the shares is the same as the price paid, there's no taxable income to report. The IRS considers the employee to have received the shares right away and the clock for long-term capital gain starts.

Without the 83(b)

Now imagine they didn't file the election. When her shares vest a few years later, the company's value has risen to $10 per share. That means they will owe taxes on $990,000 as income as either calculated as AMT or ordinary income versus the favorable tax treatment from long term capital gains.

When and how to file an 83(b) election

Timing is crucial. The IRS requires that you file an 83(b) election within 30 days of the stock purchase or grant date. There are no extensions. If you miss the deadline, the tax benefit is lost.

Here's how to file:

1. Fill out IRS Form 83(b).
2. Mail it to the IRS within 30 days (use certified mail to get proof of submission).
3. Keep a copy for your records.
4. Share a copy with your employer and consider attaching it to your annual tax return.

It's important to note that the IRS doesn't send a confirmation upon receipt. It's on you to track and document the filing.

Downsides and risks to consider

Though the tax benefits of early exercise and 83(b) are compelling, it does come with some risks:

• Upfront cost: You'll need to pay to exercise the shares — and possibly pay taxes — before knowing whether the company will succeed.
• Forfeiture risk: If you leave the company early, you might lose unvested shares without getting the taxes that you already paid back.
• Stock devaluation: If the company's value drops after you file, you've paid tax and exercise cost on a higher valuation.
• No do-overs: The 83(b) election is irrevocable. Once you file, you can't change your mind.
• Alternative minimum tax: For incentive stock options (ISOs), you might trigger alternative minimum tax (AMT) depending on the spread between strike price and fair market value. Consult a tax advisor to assess the risk.
• Liquidity risk: Early exercised shares can't be sold until there's a liquidity event — such as a tender offer, secondary, or IPO — which may be years away.

Making the 83(b) election work for you

For founders and early employees, combining early exercise with an 83(b) election can significantly reduce taxes, positioning you for even greater long-term gains. But it requires swift action, careful documentation and a clear understanding of your company's equity structure.

Executed effectively, this strategy helps turn startup equity into real wealth, without the tax shock that can accompany success. Seek professional advice to tailor the approach to your specific situation.

Planning with confidence

Understanding equity compensation strategies like early exercise and the 83(b) election is essential for startup success. At Citizens Private Bank, we work closely with founders and early employees to help them navigate these decisions, align their financial plans and prepare for liquidity events. Request more information today.