Watch for tax traps and opportunities with restricted stock

No one wants to run into unanticipated tax consequences or find out years from now there’s a tax problem. That’s why executives should carefully review the stock offerings in their compensation plans.

Restricted stock tax treatments can seem straightforward yet have traps for the unwary, such as those who choose a Section 83(b) election without knowing the full implications. Restricted stock should not be confused with restricted stock units (RSUs), which are similar but with one significant difference. With restricted stock, shares are transferred to the employee upon grant and are subject to a vesting schedule, whereas with RSUs, shares are not transferred upon grant but are promised to the employee when the stock has vested, or possibly deferred to a date beyond vesting.

A Grant Thornton LLP webcast, Taxation of stock options and restricted stock: The basics and beyond, used a hypothetical case study to offer a detailed look at the tax treatment of restricted stock. More than 1,000 participants tuned in for the presentation, and the topic of Section 83(b) elections generated particular discussion.

Specifics of restricted stock
A company’s issuance of restricted stock means the shares have been transferred to you, but those shares must be returned if you do not meet specified requirements, such as continuing to work for the company for a certain amount of time or meeting performance goals. The idea that you might not meet requirements is referred to as a substantial risk of forfeiture, discussed later.

Meet Jane Doe
Jane is a 58-year-old executive at Private Company, who hopes to retire in five years. In addition to her regular compensation, she holds incentive stock options and nonqualified stock options, discussed in Know the tax treatments for ISOs and NSOs, plus 5,000 shares of restricted stock.  

Jane reports income in the year she vests in, or accrues nonforfeitable rights to, the stock. The amount reported in income equals the stock’s value on the vesting date, minus the amount, if any, that Jane has to pay for the stock. Private Company gets a deduction for the amount Jane reported as income. Later, when Jane sells the stock, she will have a capital gain (or loss).

Ordinary income, capital gains
Say Jane receives 5,000 shares of restricted stock that vest in five years. She paid nothing for the stock. On the vesting date, the stock value is $30 per share.

Stock value at vesting date: $30
Times the number of shares: 5,000
Equals total ordinary income: $150,000

She reports income of $150,000 in the year the stock vests.

What happens if Jane sells the stock in year eight, when the fair market value (FMV) is $40 per share?

Stock price: $40
Minus Jane’s ordinary income previously recognized (her basis in the stock): $30
Equals capital gain: $10
Times the number of shares sold: 5,000
Equals total long-term capital gain (long-term because she held the stock for more than one year after vesting): $50,000

These examples represent basic tax rules for restricted stock, which can be affected by other factors.

Section 83(b) election for restricted stock: Know everything  
An 83(b) election changes the tax treatment of restricted stock. Such an election allows employees to include the FMV of the stock at the time of grant ― minus the amount, if any, paid for shares ― as income. They are not subject to additional tax until the shares are sold, at which point any gains or losses are subject to capital gains tax rates.

An individual, not an employer or a tax preparer, must make such an election and file it in writing with the IRS no later than 30 days after the date of the grant, and a copy must go to your employer. As of the writing of this article, you also must attach a copy of the form when you file your income tax return.

The election has benefits:
  • Paying tax upon grant establishes the current stock price as the cost basis for shares, and begins the capital gains holding period.
  • Gain or loss is recognized only when the stock is sold.
  • Future gains (or losses) would be taxed at the more favorable capital gains tax rates.

It also has disadvantages:

  • If the stock price decreases by the vesting date, you risk paying more tax on the grant date than you would have paid at vesting.
  • Taxes are due when the award is granted, so you must use other funds to pay the tax withholding obligation.
  • If you forfeit your stock by leaving the company for any reason before the stock vests, you would not have a capital loss for tax purposes or receive any refunds on the tax paid.  

Jane decides to make a Section 83(b) election to report income in the year the stock is transferred to her, prior to vesting.

The income amount equals the stock’s value on the transfer date, minus any amount Jane is required to pay for the stock. Private Company gets a deduction for the same amount. When Jane sells the stock, she will have a capital gain ― the holding period starts on the transfer date.

Jane receives 5,000 shares of restricted stock that vest in year five. Private Company required no payment. On the grant date, the FMV of the stock is $10 per share. Jane makes an 83(b) election:

Stock value at grant date: $10
Times number of shares: 5,000
Equals total ordinary income: $50,000

When Jane vests in the stock in year five, there will be no income recognition because she chose to have income recognized in year one.

As for her capital gains, Jane sells the stock in year eight, when the FMV is $40 per share.

Sales price: $40
Minus ordinary income previously recognized: $10 per share
Equals capital gain: $30
Times number of shares sold: 5,000
Equals total long-term capital gain: $150,000

Results with and without a Section 83(b) election
No Section 83(b) election:
Ordinary income: $150,000
Capital gain: $50,000
Total: $200,000
With a Section 83(b) election:
Ordinary income: $50,000
Capital gain: $150,000
Total: $200,000

Total income under both scenarios is $200,000, yet with the Section 83(b) election, a larger portion of the appreciation is taxed at a more favorable capital gains rate.

Can 83(b) be revoked?
Let’s say Jane did not fully understand the implications of the Section 83(b) election. The election can be revoked, but only with IRS approval and only under certain circumstances.

If revocation is sought within the first 30 days after stock is granted, the IRS will approve the revocation. After that, the IRS will approve revocation only when an individual made a “mistake of fact,” which the agency defines as “an unconscious ignorance of a fact that is material to the transaction.” Talk with a tax professional about what constitutes a mistake of fact.

Making an 83(b) election is a gamble unique in the tax code. Pay attention to what’s going on with the company so that you feel comfortable that the price of the stock will increase over time or you know that the value of the stock is extremely low, such as in the case of a startup, and you’re willing to take a chance.  

Understand substantial risk of forfeiture
“Substantial risk of forfeiture” is an important concept for restricted stock holders, because income is recognized in the year there is no longer a substantial risk of forfeiture.

Substantial risk of forfeiture means vesting that is contingent upon either of these conditions:

  • The performance of substantial services in the future (i.e., continued employment)
  • The achievement of predetermined performance goals; if the risk of forfeiture is not substantial, the stock value is included in income immediately

To determine if a risk is substantial within the vesting period requires a careful look at all the facts and circumstances. The regulations provide an example in which two years is treated as a substantial risk of forfeiture, yet that is an example only. There are no cut-and-dried rules.

Beware differences between restricted stock and RSUs
Whereas with restricted stock you receive shares of company stock on the grant date, with RSUs the shares of company stock are not transferred immediately. Instead, the company promises to transfer the stock to the employee on the vesting date or a defined date beyond vesting.

The difference is reflected in the income tax treatment. With restricted stock, the value of the stock is taxed upon vesting. With an RSU, the value of the stock is taxed on the date the stock is transferred. A Section 83(b) election cannot be made for RSUs, which may make them more attractive to employers, as employers do not have to track the election to determine their corporate tax deduction.

To summarize, tax on restricted stock can be complex, especially regarding a Section 83(b) election and the substantial risk of forfeiture. To avoid tax results you did not expect, pay attention before you act and seek professional advice if you are unclear.

Jeff Martin
T +1 202 521 1526

Eric Myszka
T +1312 602 8397

Rebecca Calvo
T +1 832 476 3778

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