First of all, you may be thinking, “Why would you ever want to do that?” Sometimes in transactions (such as a merger or acquisition), it is desirable to have management exchange otherwise vested equity for equity that vests over time in order to retain the key individuals. Aside from the obvious business considerations, the first thought that would likely occur to the holder of the equity is that this arrangement would convert the capital gain inherent in the equity to ordinary income. Obviously, this is undesirable since ordinary income is taxed at a substantially higher rate than capital gains. However, by making a Section 83(b) election, the capital gains treatment can be preserved.
Usually, when equity is subject to vesting restrictions, the service provider realizes ordinary income at the time the equity vests. Taxpayers can elect under Section 83(b) to include in income the excess of the fair market value of the unvested equity over the amount paid for that equity in the year in which it is received. Accordingly, assuming that the unvested stock received in exchange for the vested stock has the same value, there is no excess of the fair market value over the amount paid (i.e., the value of the stock given up), so there is no income to report. The fact that the transferee paid full value for the property received does not preclude the ability to make an 83(b) election.
Often, the vested equity exchanged for the unvested equity will have appreciated in value over the amount paid for it or previously included in income. This creates the potential for accelerating taxation of the gain inherent in the vested equity upon the exchange. This
would need to be carefully evaluated in a taxable exchange. However, tax on gain will not be accelerated if the exchange occurs in the context of a non-taxable transaction, such as a tax-free reorganization, a rollover of equity in a partnership, or an exchange of stock or partnership interests of one class for stock or partnership interests of another class in the same corporation or partnership.
Bottom Line: An 83(b) election can prevent converting capital gain to ordinary income when the exchange of unvested equity for vested equity is a desirable strategy.
“By trying we can easily learn to endure adversity- another man’s, I mean.” – Mark Twain