Seven Commonly Asked Questions about Restricted Stock and 83(b) Elections
By Ori Epstein, partner, and Sunny Sun, tax associate
Often with emerging startups, there is a little cash on hand to bring in key employees and incentivize them to get the company off the ground. In lieu of paying a larger salary to these employees, management of the company will often give stock as compensation for services. After all, the talent within early-stage companies is usually the most valuable asset.
But giving out stock raises additional issues. For example, what if the arrangement doesn’t work out and the employee and company part ways? A closely-held business most likely does not want to have an equity owner that has not contributed to the overall success of the company.
To address this issue, many companies give these key employees stock subject to certain restrictions. Issuing this stock, however, creates a series of tax consequences for the employee that they must be aware of. Here’s what you need to know about restricted stock, 83(b) elections and how they can help your startup and its employees.
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 four to five year period, although the range can be more or less.
At the same time, companies also subject the restricted stock to a forfeiture clause, whereby 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.
What is an 83(b) election?
The value of cash or property received as compensation during the year must be included in an employee’s taxable income. 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 his/her 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.
Why should my employees make the 83b election?
Most of the time, especially for newer startups, the value of the stock is lower at the grant date than when it fully vests. Assuming the ordinary tax rates do not 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 five-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 $1,000 per share at the second vesting date.
- Two years after that vesting date, you sell the stock for $5,000 a share.
In the example above, not making the 83(b) election costs the recipient about $4,700 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 come out pocket for $1,585 more in taxes than if the 83(b) election was made.
A Sec. 83(b) election could also let employees qualify for the 20 percent 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.
Who makes the 83(b) election?
The person who receives restricted stock as compensation makes the Sec. 83(b) election.
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.
When do my employees make 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 the 30 day timeline.
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 his or her 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.
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.