Restricted stock is a common instrument of delivering equity compensation to employees today. Stock restrictions are usually based on either the passage of time (vesting) or hitting performance goals.
At the time of the grant, there is no tax due because the property granted has a risk of forfeiture and is not transferable. When restrictions lapse, either the stock vests or the performance goals are achieved, the risk of forfeiture goes away. IRS considers the event taxable and the property received. The fair market value of the property at the time of vesting is W2 income and is subject to both ordinary income and FICA taxes.
The fair market value of the stock becomes its basis for future capital gains. Any further profit or loss is considered portfolio income and is taxed at capital gain rates, short or long, depending on how much time passed since the vesting date.
Section 83(b) election
Section 83(b) of IRC allows a taxpayer to elect to treat the forfeitable property as currently received, thereby accelerating the taxable event. In order words, instead of waiting to pay the tax on the vesting date, you can elect to pay it now.
Why would you do such a thing? Why pay now instead of later? Whether you should or shouldn’t is the subject of this post. But let us first consider what happens if you do file a letter with the IRC and evoke your election. You must do so within 30 days of the grant — the window allowed by the IRC to make the election.
Instead of getting W2 income in the amount of fair market value at the vesting date, you will incur W2 income today based on today’s fair market value of the stock. Today’s, hopefully, lower price becomes the basis for future gains, and future price increases are taxed at lower than ordinary income capital gain rates.
You are essentially converting future stock gain from ordinary income to portfolio income (see, Table 1 here, for example). The second benefit is that at the vesting date, you don’t even have to realize these already lower-taxed capital gains if you don’t sell the stock. The taxes can wait until later when you sell the stock. Potentially much later.
The caveat, of course, is that you are choosing to pay the tax you might never have to pay. After all, the property is restricted and subject to forfeiture. If you leave the company with unvested shares, you won’t receive the shares, but you have already paid the tax. You do not get the money back, nor do you get any future tax breaks. That money is gone.
Risk of forfeiture
Chances are the readers of this post, either have or are about to receive restricted stock. It is not farfetched to conclude that they are bullish on their employers. This bullishness often draws attention away from the fact that the forfeiture risk is separate and in addition to the stock performance risk.
Even if the company stock performs as expected, failure to achieve a performance threshold or continue employment can prevent the grantee from enjoying the rewards. Leaving the company does not necessarily mean being fired, keeping one’s options open, and being able to respond to career opportunities is an important consideration here.
Bob and Alice
Let’s examine two cases of Bob and Alice.
Bob is a senior manager of a well-established publicly traded company. The company’s growth expectations are reasonable, but the growth leveled off a few years ago when the company crossed into the large-cap territory. With the stock trading close to historical high paying income taxes now would present a significant cash outlay for Bob. He would have to redeem some of his mutual fund shares.
At work, Bob and another employee have been competing for a promotion. It is unclear how the competition will play out. Bob decides not to make the Section 83 (b) election and let the money he would have paid in taxes remain in the mutual fund and grow for the next few years.
If all goes well and Bob is still with his current employer when the restricted stock vests, he will pay the taxes by selling the stock at that time. In the meantime, the mutual fund will deliver a market return that, hopefully, will not be too far behind the stock.
Alice is an early startup employee. When Alice’s startup grants restricted shares to Alice, the share price is low compared to what she expects the price to be in a few years. After all, this is a startup. Being an early employee, Alice will likely be in a senior position in a few years and, conditioned on the startup doing well, might expect a salary increase.
As a consequence, her tax bracket might move a little higher. She makes an 83(b) election and has enough money to pay the tax bill because, at the moment, the share price is low. She knows that the startup might fail, or that she might leave the company, but Alice is prepared to lose the amount she paid in taxes. It is a small price to pay for not paying much larger taxes later when the price is high, and Alice is in a higher income tax bracket.
The above examples are extreme opposites of what could happen. Many times, the decision to make a Section 83(b) election is not so clear cut. It might require projections with specific income tax brackets, capital gain rates, duration of the restriction period, company outlook, whether a forfeiture event might occur, etc.