We have noted in other blog articles how “restricted stock” is a widely used form of executive compensation. Restricted stock is a grant of stock that vests over time and may or may not be tied to performance measures like year-end profitability. Restricted stock is frequently tied to length of time working for an employer. A typical grant provides that the shares will vest at the end of a fixed period, e.g., five years from the date of grant, if the executive remains employed by the company.
Any Executive who is eligible to receive restricted stock ought to know about the availability of an Internal Revenue Code Section 83(b) election. Not knowing about a Section 83(b) election could result in serious tax consequences to the Executive.
An Executive who is about to receive restricted stock should immediately consult a tax accountant or tax attorney.
I asked my law firm tax partners, Richard Sawdey and Richard Harbaugh, to give me an updated primer on Section 83(b) and they contributed substantially to this post. Here is a snapshot of Section 83(b) and why it is so important.
When a company transfers restricted stock to an Executive in connection with employment, Section 83 provides that the Executive will recognize ordinary income in an amount equal to the excess of the fair market value of the stock as of the date when they are no longer subject to a real risk of forfeiture over the amount, if any, paid for the stock.
In the example we are discussing, the Executive’s restricted shares are subject to a substantial risk of forfeiture until the five-year vesting period has expired. Thus, under Section 83, the fair market value of the stock at the end of the five-year period will be the amount of taxable income resulting from the grant.
Section 83(b) permits the executive to make an election, instead, to include the fair market value of the shares in income in the year in which the award was made. If this election is made, the amount of income is determined based on the then value of the shares without regard to the possible forfeiture of the shares.
A major caveat is that the Executive must make the election within 30 days of the Executive’s receiving the stock. The election form must be sent to the IRS office with which the Executive files his personal income tax return. Also, the election form should be sent by certified mail (return receipt requested) to ensure the executive has a record that the IRS has received it.
A Section 83(b) election requires careful consideration of the possible benefits and risks. The possible benefit is a saving of income taxes if the value of the shares at the end of the five-year vesting period is higher than their value at the time of grant. The Executive will have shielded from ordinary income tax rates the entire amount of the appreciation during the vesting period. Upon a later sale of the shares, the appreciation that took place during the vesting period will instead be taxed as capital gain.
However, the election also carries significant risks. If the Executive’s employment is terminated during the vesting period and a Section 83(b) election was made, the Executive will forfeit the shares but will not be entitled to a deduction for the income taxes paid in the year of the grant. Thus, taxes will have been paid on shares that never will be received.
If the Executive believes the stock will rise in value, believes there is little risk of forfeiture of the stock, and knows that the income that will be reported upon election will be modest, then there may be a strong case to make the Section 83(b) election.
In the context of a restricted stock grant with a five-year vesting period, in our example, the safest, lowest risk course is to forgo a Section 83(b) election and recognize the income in the year when the grant vests. The Executive knows in that case that he is paying tax on stock that he owns and that he has avoided the out-of-pocket tax cost that could have resulted had he paid the income tax when he received the stock followed by forfeiture of the very same stock.
Again, the Executive should immediately consult with a tax accountant or tax attorney to analyze the Executive’s particular employment situation and stock restrictions to determine whether a Section 83(b) election makes sense and to accomplish the election in a timely fashion when the election is warranted.