If an employer grants one of its employees a restricted stock award, should that employee make an 83(b) election at the time the restricted stock award is granted? What is the upside to the employee if he or she makes an 83(b) election? What are the risks to the employee? The answers to those questions are this “Tip of the Week.”
The question of an 83(b) election applies any time an employer grants certain restricted stock to an employee (i.e., restricted due to a time-based and/or performance-based vesting schedule). The primary objective of an 83(b) election is for the employee to maximize his or her capital gains treatment with respect to any appreciation in the restricted stock award from the date of grant. [Note: though this Post addresses restricted stock, the concept of an 83(b) election also applies to other forms of property]. For example:
- Employee Does Not Make an 83(b) Election. Because a vesting schedule applies, the employee would have no taxable income on the date the restricted stock is granted to the employee. Any dividends received by the employee due to his or her holding restricted stock would be treated for tax purposes as compensatory (i.e., ordinary income tax treatment subject to withholding). Assuming the restricted stock award becomes vested, the employee would recognize ordinary taxable income (subject to employer withholding) on the vesting date equal to the then fair market value of the award. And if the vested stock is later sold by the employee, then the spread between the sale price and the fair market value of the award at the time the award became vested would be treated as capital gain to the employee (taxed at long-term rates if the stock was held by the employee for at least one year from the vesting date).
- Employee Makes a Timely 83(b) Election. The employee could attempt to capture as much of the projected appreciation in the award at capital gains rates if the employee made an 83(b) election within 30 days from the date the restricted stock award was granted to him or her. The reason for making an 83(b) election is for the employee to limit the amount ordinary income he or she would recognize if, from the date of grant through the vesting date, the stock were to appreciate in value. However, the downside of an 83(b) election is that the employee would recognize ordinary income on the date of grant (equal to the then fair market value of the restricted stock) even though such restricted stock could become forfeited pursuant to the vesting schedule. The employer would have a withholding obligation at such time. No taxation would result if the restricted stock award becomes vested. And if the vested stock is later sold by the employee, then the spread between the fair market of the award on the grant date and the sale price would be captured by the employee at capital gains rates (taxed at long-term rates if the stock was held by the employee for at least one year from the date the award was granted).
From an economic perspective, the employee is generally better off making an 83(b) election IF: (i) the vesting shedule becomes satisfied (e.g., no forfeiture of the award due to the employee terminating employment) AND (ii) the fair market value of the award appreciates from the date of grant.
Consider the Following Example
On February 1, 2017, the employee receives 10,000 shares of restricted stock subject to a two-year cliff vesting schedule (i.e., nothing vests until the 2nd anniversary of the grant date and then only if the employee is still employed with the employer). Each share is worth $10 on the date of grant. On February 1, 2019 (the date of vesting), each share is worth $30. The employee then sells the shares for $400,000 on May 1, 2019, at $40 per share.
- If an 83(b) election IS timely filed:
|Ordinary income upon grant 2/1/17:||$100,000|
|Ordinary income tax 2/1/17 (40% x $100,000):||$ 40,000|
|Ordinary income upon vesting 1/31/19:||– – – – –|
|Capital gain at sale 5/1/19 ($400,000 – $100,000):||$300,000|
|Capital gains tax 5/1/19 (23.8% x $300,000):||$ 71,400|
|Aggregate Tax on Award:||$111,400|
- If an 83(b) election is NOT filed:
|Ordinary income upon grant 2/1/17:||– – – – –|
|Ordinary income upon vesting 1/31/19:||$300,000|
|Ordinary income tax 1/31/17 (40% x $300,000):||$120,000|
|Capital gain at sale 5/1/19 ($400,000 – $300,000):||$100,000|
|Capital gains tax 5/1/19 (23.8% x $100,000):||$ 23,800|
|Aggregate Tax on Award:||$143,800|
In this example, the tax cost to the employee for failing to make an 83(b) election is $32,400 ($143,800 less $111,400).
Thoughts to Consider
- There is a direct correlation between the value of the restricted stock during the vesting schedule and the tax cost to the employee for failing to make an 83(b) election (e.g., the more the appreciation, the more the tax cost for failing to make the election).
- When determining whether to make an 83(b) election, the employee must carefully consider the risk of his or her employment being terminated prior to the award become vested. To highlight this issue using the above example, if the employee filed an 83(b) election but his or her employment was terminated prior to the award becoming vested on January 31, 2019, then the employee would have forfeited his or her shares, and the employee would have paid $40,000 in ordinary income tax. In contrast, if the employee had not filed an 83(b) election and his or her employment was terminated prior the award becoming vested, then the shares would still have become forfeited, but the upside is that the employee would have conserved the $40,000 cash outlay (i.e., he or she would not have paid any ordinary income tax).
- Worth noting is that some employers help negate the above economic risk by providing the employee with a tax gross-up. A sample gross-up formula is as follows: Total Tax Gross-Up = [(Fair Market Value of the Award on the Date of Grant) divided by (1 minus the Employee’s Tax Rate)], minus the Fair Market of the Award on the Date of Grant.