Restricted Stock: Should You Pay Tax Now or Later?

For growing companies, equity-based compensation is a powerful tool for attracting and retaining executives and other key employees. If you receive an award of restricted stock or purchase shares subject to vesting, consider making an election under Internal Revenue Code Section 83(b) to accelerate taxable income associated with the stock.

2 ways Sec. 83(b) reduces taxes

Accelerating income may seem counterintuitive, but if the stock’s growth prospects are strong and the risk of forfeiture is low, a Sec. 83(b) election can generate significant tax savings. Ordinarily, restricted stock isn’t subject to tax until it vests. At that time, however, you’re subject to tax at ordinary-income rates on the stock’s vesting-date value (less the purchase price you paid, if any). This can result in a substantial tax bill if the stock has appreciated significantly in value.

A Sec. 83(b) election can reduce your taxes in two ways:

  1. If the stock’s value increases, the election minimizes ordinary-income taxes by allowing you to pay the tax on the grant or purchase date value rather than on the vesting date value. If you purchase the stock at its fair market value, you’ll recognize zero income on the purchase date.
  2. It accelerates the start of the one-year long-term capital gains holding period to the grant or purchase date rather than the vesting date. Remember, long-term capital gains rates are lower than ordinary-income rates.

Bear in mind that you can’t take too long to decide whether to make the election: You have only 30 days from the award or purchase date.

A Sec. 83(b) election in action

Let’s say Heather’s employer grants her 10,000 shares of restricted stock with a fair market value of $1 per share. When the stock vests one year later, its value has grown to $10 per share. Heather sells the stock a year after the vesting date for $25 per share. Assume that Heather is in the 35% tax bracket and that her long-term capital gains tax rate is 15%. (To keep things simple, we’ll ignore state and payroll taxes.)

If Heather doesn’t make a Sec. 83(b) election, no tax will be due when the stock is granted. When the stock vests, however, Heather will recognize $100,000 in ordinary income (10,000 × $10), resulting in a $35,000 tax bill. When Heather sells the stock a year later, she’ll recognize a long-term capital gain on the stock’s additional appreciation of $15 per share, resulting in a $22,500 tax bill (10,000 × $15 × 15%). Heather’s total tax liability is $57,500.

Now, let’s assume that Heather files a timely Sec. 83(b) election when the stock is granted. She’ll pay tax on $10,000 in ordinary income as of the grant date ($3,500), but when she sells the stock two years later, all of its appreciation in value ($24 per share) will be treated as a long-term capital gain, resulting in a $36,000 tax bill (10,000 × $24 × 15%). Her total tax liability is $39,500. By making the election, Heather enjoys $18,000 in tax savings.

Consider the risks

Be aware that a Sec. 83(b) election isn’t risk-free. If you forfeit the stock (because, for example, you leave the company before it vests) or the stock declines in value, you’ll have paid tax on income you didn’t receive. You also might end up paying more tax than necessary if tax rates go down. Your tax advisor can help you weigh the pros and cons.

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