One of the most common tax-related concepts that arises in discussions with employees in connection with the issuance of restricted stock is a Section 83(b) election. So, what exactly is an 83(b) election and how is it helpful to an employee?
Section 83 of the U.S. tax code establishes a time frame in which restricted stock is to be included in income, such that the value is includable as gross income at the moment the rights in the stock are transferrable or are no longer subject to substantial risk of forfeiture, whichever comes first. This means that when an employee receives restricted stock that only begins to vest after a year, under Section 83(a), the employee would not recognize any income upon the initial grant. Instead, the fair market value of the stock is recognized by the employee as compensation, valued as and when it vests. This can be quite problematic for the employee, as the amount of taxes owed by the employee can become quite significant on the later vesting date and the employee may not have otherwise received the cash he or she needs to pay these tax amounts.
Section 83(b) provides a helpful solution for the employee in this circumstance. By writing a letter to the IRS (what is called a Section 83(b) election), within 30 days of the original time of the granting of the receipt of the restricted shares, the employee elects to recognize the fair market value of the restricted stock as measured on the date the shares were granted. (Do not forget the 30 day rule! It is a hard and fast deadline! Also note that in addition to notifying the IRS, a copy of the election must be submitted to the employer and included in the employee’s annual tax return) By making the Section 83(b) election, the employee is accelerating the payment of ordinary income tax in a way that can have substantial savings. Assuming the employee did not pay anything for the restricted stock, the ordinary income tax will be on the value of the restricted stock at the time of the grant, and if the employee subsequently sells the restricted shares at a time that is more than one year from the time of the grant, the additional gain will be taxed at the lower capital gains rate. Here is an example that demonstrates the potential advantage of the election:
Assume that the employee receives 1,000 shares subject to vesting. At the time of the grant the shares are each worth $1, the shares are then worth $5 each at the time of vesting and $10 each when they are sold more than one year later.
Scenario in which a Section 83(b) election is made: At the time of granting the shares are worth $1,000 (1,000 * 1), and thus ordinary income taxes are paid on the $1,000. No taxes are due at the time the shares vest. At a later sale that takes place more than one year from the date of the grant, the shares are sold for $10,000 (1,000 * 10), and a long term capital gain rate will be imposed on the gain of $9,000.
Scenario in which a Section 83(b) election is not made: No taxes are paid at the time of the grant. At vesting, ordinary income taxes are paid on the $5,000 of shares received (1,000 * 5). At a later sale that takes place more than one year from the date of the vesting, the shares are sold for $10,000 (1,000 * 10), and a long term capital gain rate will be imposed on the gain of $5,000.
It is also important to realize that there is an inherent risk with the filing of the Section 83(b) election, because it is possible that the value of the shares actually decreases in value. Moreover, the company may enter bankruptcy causing its shares to become worthless. In these scenarios, it can turn out that the employee accelerated the payments of income tax on shares that actually decrease in value from the time the taxes are paid. It is also possible that the employee leaves the company before the shares have fully vested and thus taxes were paid on shares that he or she will never actually receive.
As discussed in this summary, whether a Section 83(b) election will be made will directly impact the tax consequences upon grant of restricted stock to employees.