Restricted Stock and 83(b) Elections: 7 Common Questions
By: Ori Epstein, partner, and Sunny Sun, tax associate
Emerging startups wanting to hire and incentivize key members of the team will often give stock in lieu of paying big salaries. The right talent is the company’s most valuable asset and providing stock options can be a great way to support growth without burning through funds.
But giving out stock can raise issues. What if things don’t work out and those employees leave the company? Closely held businesses probably don’t want equity owners who haven’t contributed significantly to the success of the business.
To address this, many companies give these key employees stock subject to certain restrictions. In turn, that creates tax consequences for those employees.
Here’s what you need to know about restricted stock, 83(b) elections and how they can help your startup and its employees.
1. What is restricted stock?
Restricted stock is usually subject to certain defined restrictions, such as vesting and forfeiture.
Vesting refers to the period of time over which the recipient gains outright ownership of the stock. In many cases, vesting occurs over a 4–5-year period, although the range can be more or less.
At the same time, companies also subject the restricted stock to a forfeiture clause. This means that if the employees leave the company before the stock is fully vested, they lose all rights to the stock and it is returned to the company.
2. What is an 83(b) election?
An employee’s taxable income must include the value of cash or property received as compensation during the year.
Section 83(b) grants any person who performs services in exchange for property the option to include the value of the entire stock, vested and unvested, in their gross income in the initial year of receipt.
Essentially, employees have the option to include the stock compensation either at the grant date or as the stock vests.
3. Why should my employees make the 83(b) election?
Usually, the value of the stock is lower at the grant date than when it fully vests.
If ordinary tax rates don’t change, making the election may provide substantial tax savings to the employee.
The potential benefit of making an 83(b) election is best illustrated through an example.
Imagine the following scenario:
- Startup, Inc. agrees to grant each founder 10 shares of restricted stock as compensation.
- Each restricted stock is subject to a 5-year vesting period, with the first restriction lapsing at the end of the first year.
- At the grant date, the stock is worth $1 per share.
- Startup, Inc. releases its product to a wave of fanfare and immediately has offers to invest or outright buy the company. Based on this information, the value of the stock increases to $1000 per share at the second vesting date.
- Two years after that vesting date, you sell the stock for $5000 a share.
In the example above, not making the 83(b) election costs the recipient about $4700 in additional taxes. If you didn’t make the election, you would pay $14,704 in taxes, but by making the 83(b) election you only pay $10,002.
Additionally, the recipient of stock compensation usually must come out of pocket to pay the related tax liability as the stock vests. In the example above, not making the 83(b) election causes the recipient to pay $1585 more in taxes than if the 83(b) election were made.
A Section 83(b) election could also let employees qualify for the 20% long-term capital gain rate sooner. Once their stock is taxed at the grant date, the timer for calculating long-term capital gain begins. If they don’t make the election, the gain will not count as a long-term capital gain until it is held at least one year from the vesting date.
4. Who makes the 83(b) election?
The person who receives restricted stock as compensation makes the Section 83(b) election.
5. How do my employees make the 83(b) election?
Making an 83(b) election is simple. The election is a one-page letter filed with the IRS that includes the following information:
- Recipient’s name
- Recipient’s social security number
- Recipient’s address
- A description of the property received (for example: 100 shares of Startup, Inc.)
- The date that the stock was transferred to the recipient
- The fair market value of the stock at the time of transfer
- The amount, if any, that the recipient paid for the stock
- The amount that the recipient will include in gross income on his or her personal income tax return
The letter must be signed by the person making the election.
6. When do my employees make the 83(b) election?
While the election itself is fairly simple to complete, the filing itself is far more critical.
IRS rules require that the election be filed no later than 30 days after the stock grant date. Your employees will not be able to make this election after those 30 days are up.
7. Where do my employees file the 83(b) election?
The taxpayer will file the Section 83(b) election with the Internal Revenue Office with which the taxpayer files their annual income tax return. A copy of the election should also be provided to the company that granted the stock.
Issuing stock to key employees is a great way to incentivize efforts and contribute to the overall success of a company.
However, recipients need to be aware of and plan for the various tax consequences associated with receiving this stock. You should consult with your tax advisor on how to set up a restricted stock plan and how best to educate your employees.
Do you have questions about awarding or receiving restricted stock? Contact Ori Epstein at firstname.lastname@example.org.
Any tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or under any state or local tax law or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. Please do not hesitate to contact us if you have any questions regarding the matter.