United States: Evaluating Tax Options On Restricted Stock Awards

Last Updated: November 1 2017
Article by Thomas Kosinski

Employers have offered key employees numerous types of incentives and awards, including stock options, stock appreciation rights and cash bonuses. One common alternative provides restricted stock to attract, retain and motivate key employees. However, in order to fully enjoy the benefits of restricted stock awards, employees need to be careful with how taxes will be treated because many recipients are unaware that cash is not the sole method in which awards are taxable. For example, a Section 83(b) election is a tax election that accelerates taxes on restricted stock, but the benefit could deliver substantial overall tax savings in the future.

Taxing Dilemma

When an employer grants restricted stock to an employee, the stock is non-transferable and can be forfeited until it vests. Vesting is one of the terms of the stock and is generally based on years of service and achievement of performance goals.

Under Internal Revenue Code Section 83, restricted stock is not subject to tax when granted if it still has a risk of forfeiture. Rather, its value is included in gross taxable income as compensation only if the stock vests. If your stock appreciates significantly in value, you could end up with a big tax bill—at ordinary income tax rates that apply to compensation—before you get any cash to pay the tax liability. One choice is to sell the stock to raise cash for taxes. After the date that the stock vests, any additional appreciation in value is included in taxable income and treated as capital gain.

One Possible Solution

To help you avoid owing taxes that you cannot pay, Section 83(b) provides an election to be taxed at the time restricted stock is granted.

Such an election provides two important advantages:

  • If you believe the stock's value will grow, the election allows you to minimize the amount of ordinary income and pay more capital gain taxes later when the stock vests; and
  • It triggers a holding period for owning the stock, so you can pay long-term capital gain rates if you sell the stock at least one year after the grant date, rather than one year after it vests.

For example, suppose that your employer grants you 100,000 shares of restricted stock valued at $0.10 per share and vesting one year after the grant date. Assume that the stock is worth $2 per share a year later when it vests and $10 per share when you sell it after one year. If you are currently in the 35% federal income tax bracket and the long-term capital gain rate is 20%, you will have some alternatives that will impact your income taxes.

Under one scenario, you do not make an 83(b) election. No tax is due when the stock is granted, but you will owe $70,000 in income taxes when it vests (100,000 shares × $2/share × 35% rate). When you sell the stock a year after it vests, you will recognize a taxable capital gain of $8 per share ($10/share minus $2/share that was already taxed) for an additional $160,000 in tax (100,000 shares × $8/share × 20% rate). Your income tax liability in the long term is $230,000.

Under a second scenario, you do file an 83(b) election when the stock is granted, paying a much smaller $3,500 in income taxes (100,000/share × $0.10/share × 35% rate) at the date of the grant. When you sell the stock two years later (one year after vesting), your entire $9.90 per share gain is treated as long-term capital gain for an additional $198,000 in tax (100,000 shares × $9.90/share × 20% rate). Your income total tax liability in the long term is $201,500.

The 83(b) election potentially results in a $28,500 tax savings. In this second scenario, you also pay only $3,500 in taxes up front, which avoids a larger tax bill when the stock vests and you have not yet received cash from the stock sale. However, there are additional tax factors that could impact the amount of tax you owe, including payroll taxes for compensation and your resident state tax, so it is important to consider the overall tax liability and the timing for the taxes that you owe.

Not Without Risk

Despite some significant benefits, an 83(b) election comes with certain economic risks. First, there is an additional risk of loss associated with owning any stock. However, with restricted stock you may have circumstances that require you to forfeit the stock, such as not meeting performance targets or leaving your job before the stock vests. If so, you may have paid tax at ordinary tax rates on stock you never received, although eventually you may have a capital loss that could have deduction limitations.

Carefully weigh your economic risks against the tax advantages if you receive restricted stock. If you want to take advantage of the Section 83(b) election, consult with your tax advisor at ORBA regarding your specific situation. The last limitation to be aware of is to file elections with the IRS within 30 days after the restricted stock is granted. It is imperative to provide a copy to your employer for valid and timely elections before tax deadlines.

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.

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Thomas Kosinski
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