In certain circumstances, an employee may receive restricted stock as part of their compensation package. Restricted stock is a type of equity compensation in which the employee (perhaps a corporate executive, startup founder, or startup employee) receives shares of company stock that are subject to specified restrictions. These may include a vesting schedule or other conditions that must be met before the employee gains full ownership of the shares.
The incentive behind this type of compensation is simple—if the value of the company increases, the value of the employee’s shares will increase as well. However, when an employee receives compensation of equity in a company, it is subject to income tax according to its value. In general, the fair market value of the stock when it is granted or transferred serves as the basis for assessing the tax liability, with the tax due in the year that the stock is issued or transferred. In cases where restricted stock vests over several years, the tax would be due on the value of the portion that vests each year.
If the value of the stock rises each year, the amount of tax also rises, potentially adding up to a hefty tax bill. Taking an 83(b) election can enable someone to lower their taxes on compensation received as restricted stock—but it has risks that must be carefully considered first.
What Is an 83(b) Election?
An 83(b) election is a provision of the Internal Revenue Code that gives an individual receiving restricted stock as compensation the option to pay taxes on the total fair market value of restricted stock at the time of granting, rather than when the stock vests. The employee pays no additional income tax when the shares vest (although they would owe capital gains tax if the shares are then sold at a profit). The advantage is clear if the stock rises in value during the vesting period—the employee could potentially pay much less in income tax if they choose to pay it all when the stock valuation is low.
To make an 83(b) election, the employee must file a written statement with the Internal Revenue Service (IRS) within 30 days of receiving the restricted stock to alert the agency to tax them at the time of granting, rather than when the stock vests. The statement must include specific information about the employee, the employer, and the stock being granted, as well as the declaration of the 83(b) election. There is no grace period or ability to request an extension of this 30 days filing requirement, so it is imperative to timely file with the IRS.
The Risks of an 83(b) Election
An 83(b) election might be worth considering if the amount of income reported would be small at the time of granting, and if there is considerable confidence that the value of the stock will grow. It may not make much sense if the amount of income reported would be high when the stock is granted (as when stock in a well-established corporation forms part of an executive compensation package, for instance). However, this tax strategy is not without risk.
If the value of stock decreases after the election is made, the employee may have paid more taxes than would have been necessary had they paid as the shares vested instead of up front. The IRS does not allow an overpayment claim of taxes under an 83(b) election, so taking the election can be a gamble. Additionally, if an employee doesn’t meet the conditions for vesting or loses their job before all the shares have vested, they may forfeit some or all of the shares they were granted initially. In that case, they may have paid taxes on equity they never received. Again, this amount is not recoverable after the fact.
Considering an 83(b) Election
Given the significant tax implications, potential benefits, and risks involved, there is no one right answer for whether an employee should opt for an 83(b) election when receiving restricted stock as compensation. Employees should consult a qualified attorney and tax professional before making such an election to understand how it would affect their individual tax circumstances and to evaluate the risks involved in their case. They should also review the terms of their restricted stock agreement and consider their own financial situation and goals to determine if the potential benefit is worth the risk.
If you need help determining whether an 83(b) election is in your best interests, Bridge Law LLP can help. Our corporate and tax advisory team specializes in working with our clients and their tax professionals to create strategies that help eliminate or substantially reduce your tax liability. To find out more, contact us here to schedule a consultation.