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.

Two Ways Section 83(b) Reduces Taxes

Accelerating income may seem illogical, but if the stock's growth prospects are strong and the risk of forfeiture is low, a Section 83(b) election can generate significant tax savings. Ordinarily, restricted stock is not subject to tax until it vests. However, you will be subject to tax at ordinary rates of the value on the stock's vesting date (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 Section 83(b) election can reduce your taxes in two ways:

  • 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 will recognize zero income on the purchase date; and
  • It accelerates the start of the 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.

Keep in mind that you cannot take too long to decide whether or not to make the election. You have only 30 days from the award or purchase date.

Section 83(b) Election in Action

For example, 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. This assumes that Heather is in the 35% tax bracket and that her long-term capital gains tax rate is 15%. If Heather does not make a Section 83(b) election, no tax will be due when the stock is granted. When the stock vests, she 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 will 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 Section 83(b) election when the stock is granted. She will 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 Section 83(b) election is not a risk-free decision. If you forfeit the stock or if the stock declines in value, then you will have paid tax on income that you did not 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.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.