Understanding the 83(b) Election and Restricted Stock
How The 83(b) Election Can Effect The Taxation of Restricted Company Stock
The 83(b) election must be made within 30 days of receiving restricted stock and can substantially reduce the associated tax liability. Making the 83(b) election can be beneficial for the recipient of restricted stock, as it allows them to recognize the full economic value of the stock at the time of vesting, rather than when it is actually sold.
Companies can award their employees with various forms of equity compensation. One of the most common forms is Restricted Stock. There are two main types of Restricted Stock, Restricted Stock Awards (RSA) and Restricted Stock Units (RSU).
We have already discussed RSUs and how they work in another article (please click here to see it). This article will discuss RSAs and the beneficial 83(b) election that can be made on them.
Restricted Stock Awards
Like RSUs, RSAs have a specified number of shares given to the employee, laid out by a vesting schedule. With RSUs, these shares are outlined at the grant date but are not actually issued until the shares vest. This differs from an RSA where at the grant date, the shares are issued and held in escrow until they are vested to the employee.
This means that all the shares issued under an RSA are considered issued and outstanding at the grant date as opposed to the vesting date. These issued and outstanding shares under an RSA also allow the employee to have voting rights even before vesting. RSAs also allow the shares to receive dividends before they vest.
The vesting schedule of RSAs is the same as RSUs. The shares are given to the employee based on achieving specific work milestones whether time or performance based. These RSA shares, like RSUs, are taxed when they vest, and the tax is calculated based on the shares received multiplied by the Fair Market Value (FMV) of the shares on the vesting date. This amount is taxed as ordinary income.
Because of this most employees that have RSAs must immediately sell some of their vested shares to pay the tax bill. The holding period for capital gains consideration of the shares starts at the vesting date and must be held a year from this date to qualify for these preferential tax rates. RSAs also have a tax election that is not offered to RSU recipients.
Restricted Stock and The 83(b)
Section 83(b) election is an Internal Revenue Code section created by the IRS to allow RSA holders to pay taxes on their shares at the grant date instead of the vesting date. The employee must send this election form to the IRS no more than 30 days past the grant date of the RSA. The completed 83(b) IRS form should also be sent to the employer.
This election should be made by employees who believe they have a strong chance of meeting their time or performance milestones and believe the company’s stock will appreciate over their vesting schedule. The section 83(b) election works by taxing the FMV of all the RSA shares at the grant date. This means that the employee is paying taxes on shares they have not physically received yet. Think of this as a pre-payment of taxes.
Then, when the shares vest to the employee on the vest date, there is no tax bill and the employee’s basis in the shares is what they paid per share at the grant date. This does not change the holding period calculation for long-term capital gains as the vested shares must still be held for a year before receiving the preferential capital gains rates.
Let’s say that an individual named Pat has been working for a company for the past 5 years. As an added benefit, Pat’s company offers him a restricted stock award of 5,000 shares that will vest 20% every year starting the second year after the award was granted.
Pat’s company stock is $20 on the date of the grant, $25 in years 2 and 3, $20 in years 4 and 5, $25 in year 6, and $38 at the point of sale in year 10.
For this example, we need to make a few assumptions:
- Pat is in the 32% tax bracket while working
- Pat will be in the 22% tax bracket when retired
- Pat will stay with the company long enough to receive the full award
Over this 10-year period, Pat will be able to save $8,925 in taxes by making the 83(b) election and paying the ordinary income taxes on the shares up front. For the full tax calculation, please see the disclosures below.
As with everything, the IRS does not give any tax benefits without the risk of potential downsides. With the 83(b) election, the risk is that if the milestones are not met (i.e., the employee leaves the company before the shares vest) the tax dollars paid on the grant date cannot be recouped by the employee.
Along with this risk, the company’s share price could decrease by the time the shares vest. This is a risk because if the employee had waited to pay the tax until the vest date, they would have had a lower amount reported on their income. This is why it is essential to talk with your financial advisor, walk through the potential scenarios, and see if the section 83(b) election is the right choice for you.
Need Some Help?
If you’d like some help from a CPA or CERTIFIED FINANCIAL PLANNER (CFP®) advisor regarding this strategy and how it applies to you, the Rhame & Gorrell Wealth Management team is here to help.
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