A big decision when you receive restricted stock is to make an 83b election or not. An 83b election lets the IRS know you want to pre-pay tax when the restricted stock is granted rather than the vesting date. If you expect the stock to be much higher when it vests, this can be a lucrative deal — paying taxes on a much smaller amount. This can also maximize the capital gains treatment, which is typically more favorable than ordinary income tax. However, while 83b might seem like a great deal, it does come with drawbacks. We will cover the mechanics of the 83b election and if it’s right for you.
Restricted stock is precisely that — restricted. Meaning it cannot be transferred until certain conditions are met — a vesting period, trigger, or performance metrics.
Both private and public companies use equity awards such as restricted stock. Like other forms of equity compensation, it’s a way to attract and retain talent in hopes of future growth. However, restricted stock isn’t to be confused with RSUs (restricted stock units). RSUs don’t have the option to elect 83b.
The reason for making an 83b election is to minimize taxes and maximize the money that you keep potentially. When you make an 83b election, you pay ordinary income tax on the value of the shares on the grant date. Once the restricted stock has vested, the shares are yours to continue holding or sell.
Since you pay taxes on the restricted stock at grant, there is no tax obligation once the shares vest. When the shares are sold, any gain between the stock price on the grant date and the sale price will recognize capital gains. Thus, holding the shares more than one year after the grant date will result in more favorable long-term capital gains. This can result in big tax savings, as we will see in an example later.
If an 83b election is not filed, there is no tax due when restricted stock is granted. Rather when the shares vest, you would owe ordinary income tax at the fair market value. If the shares have increased substantially between the time of grant and vest, you could pay much more in taxes by not electing 83b.
With the potential tax savings, there is the risk you’ll pay taxes on something you never receive. If you leave the company or give up your right to the shares before vesting, you pay tax on shares that are never owned. For example, if you elect 83b, pay the tax, and leave the company before the restricted stock vests, you’ll be out the money you paid in tax. Once you pay taxes on the restricted stock with an 83b election, you don’t get that money back whether you end up owning the shares or not.
An employee receives 5,000 shares of restricted stock with a 3-year cliff vesting schedule on 5/1/2019. On the grant date, each share is worth $10.00. Fast forward to the vesting date 3 years later, or 5/1/2022, and the stock is worth $40.00. The employee then sells the shares on 12/1/2022 at $45.00 per share. Let’s assume this employee is in the 32% tax bracket and 15% capital gains rate. Because of a high income, this employee is also subject to the extra medicare surtax on investment income which adds 3.8% on capital gains.
If the employee filed an 83b:
If the employee did not file an 83b:
As you can see in this example, the cost of not electing the 83b is $19,800. If the employee elected 83b and left the company within the 3 year vesting period, they forfeit the $16,000 tax payment and will not receive the shares.
You must file an 83b election within 30 days of the award date. This is generally irrevocable.
As with any investment, the future is uncertain. The reason risks exist is because of the uncertainty of what can happen in the future. There are two main reasons that the 83b election can be worth it. Both of these require you to look into the future using a crystal ball. Or at least understand the long-term value of your decision.
Since 83b elections are irrevocable once made, it’s important to work with your CERTIFIED FINANCIAL PLANNER™ or tax advisor. The investment to have someone guide you through big financial decisions is worth the peace of mind and potential savings. The decision to elect 83b or not requires a thorough analysis that considers your entire financial plan. This will help maximize your equity and minimize payments to Uncle Sam. If you need to talk through your equity compensation or restricted stock, let’s chat.
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