A restricted stock award is a type of stock compensation where founders or employees are granted shares of company stock subject to vesting requirements. Recipients of restricted stock must decide whether to make an 83(b) election within 30 days of grant. With an 83(b) election, the unvested stock is purchased and ordinary income recognized on the taxable spread (if any). Although very similar to restricted stock units, restricted stock awards are not the same thing. If you have restricted stock awards, here’s everything you need to know about your grant.
This article will cover the following topics:
- What is a restricted stock?
- Restricted stock and taxes
- Should you make an 83(b) tax election?
- Restricted stock vs restricted stock units (RSUs)
- Restricted stock awards vs stock options
- Additional equity compensation resources
What is restricted stock?
A restricted stock award is a type of equity compensation. Employees are given (or may buy) shares of company stock. Shares are earned when vesting requirements are met.
Depending on the stock plan and terms of the grant at the company, a restricted stock award (RSA) will include varying features:
- Cost. Shares in RSAs can be given to employees, at a discount to fair market value (FMV), or at the current market price.
- Vesting requirements. Vesting requirements for restricted stock awards can be time-based or performance-based. If you leave the company prior to vesting or the performance requirements aren’t met, you will typically forfeit the shares. Time-based vesting is often gradual where vesting occurs between 3 – 5 years. The company will often repurchase the shares for the same price you paid, assuming you made an 83(b) election.
- Upon vesting. If vesting requirements are met, the company may deliver the shares, a cash equivalent, or a combination, but usually stock. The higher the purchase price, the greater the risk the shares could become underwater.
Restricted stock units vs restricted stock
What’s the difference between restricted stock vs restricted stock units? Restricted stock units (RSUs) are similar to a restricted stock award in a number of ways but there are a few key differences. In either type of equity plan, vesting may be time or performance-based and cash or shares could be delivered upon vesting.
Unlike restricted stock, employees don’t pay for RSUs. Therefore, unless the stock goes to $0, vested restricted stock units always have some value.
Assuming a restricted stock award recipient doesn’t make an 83(b) election, the tax treatment for RSUs and RSAs will be the same for employees of publicly traded companies. An 83(b) tax election isn’t allowed withRSUs. Some other differences include receipt of dividends and voting rights for restricted stock award.
Restricted stock awards vs stock options
In many ways, nonqualified stock options are similar to restricted stock (when there’s a purchase price). But if you’re granted stock options, you don’t have equity until your grants vest and you exercise your stock options. There are two kinds of stock options: non-qualified (NQSOs) and incentive stock options (ISOs). Here are the key differences between restricted stock and stock options:
- Restricted stock awards can be given or purchased at fair market value or a discount. Stock options must be purchased.
- Stock options are only worth something if the market value at vesting is greater than the exercise price. If restricted stock is given to you, shares will always be worth something unless the stock goes to $0.
- Assuming the grant is accepted and an 83(b) election is NOT made, restricted stock will automatically trigger a taxable event when the stock vests. Liquidity issues can and do happen.
How restricted stock awards are taxed
Regular tax treatment of restricted stock
The default taxation of restricted stock awards is as follows: no tax is due when the grant is accepted, but at vesting, the difference between the fair market value of the stock and the amount you paid for the shares (if any) is ordinary income. If you receive cash instead of shares or opt to sell the shares immediately upon vesting, there will be no additional tax consequences. When you recognize income, your new tax basis becomes the value of the shares at that time.
Short or long-term gains tax will apply to the subsequent gain (if any) when the shares are later sold. The capital gains tax rate will depend on your holding period. Long-term gains are taxed more favorably than short-term, where the tax rates are the same as ordinary income.
Choosing an 83(b) tax election
An 83(b) tax election allows restricted stockholders to pay ordinary income tax on the award before it vests. This is common. Tax implications follow the explanation above.
Here’s a simple example of how restricted stock is taxed
Examples ignore the other taxes that may apply (Medicare, FICA, etc.) for simplicity.
No 83(b)/regular tax method:
Ben accepts an award of 100 shares of stock for $0/share when the stock is valued at $5/share. Subject to time-based vesting, 2 years later, the restrictions lapse in full when the stock is trading at $50/share. Ben holds the stock for 13 months, then sells all 100 shares when the stock price is $60/share.
At vesting, Ben owes ordinary income tax on the difference between the stock price at vesting ($50) and what he paid for the shares ($0), multiplied by the number of shares. In this example, $5,000 is included in his regular federally taxable income. Ben’s new basis is $50/share. When he sells the stock after meeting the long-term capital gain holding requirements, he will have a capital gain of ($60 – $50) x 100 = $1,000.
Summary:
- Taxed when shares vest
- If shares aren’t sold at vesting, capital gains holding period starts at vesting
- Any further gain or loss after vesting is a short or long-term capital gain/loss calculated using the new basis from when the stock vests
- Total tax paid estimate: ($5,000 * 35%) + ($1,000 * 20%) = $1,950
83(b) election:
Using the previous assumptions, but now Ben makes an 83(b) tax election. Within 30 days of accepting the grant, Ben makes an irrevocable 83(b) election with the IRS and notifies his employer. Though he has 2 years until his shares vest, he must pay ordinary income tax on the difference between the valuation at grant ($5 x 100 = $500) and what he paid for the shares ($0). Ben’s new basis is $5/share and his holding period starts now, even though he doesn’t own the stock.
Two years later, Ben is fully vested, but since he plans to hold the shares, there are no tax consequences. When he sells the stock 13 months later, he will have a long-term capital gain of ($60 – $5) x 100 = $5,500.
Summary:
- Taxed upon filing 83(b) election. There is NO refund of tax paid if shares are forfeited before vesting!
- No further tax implications until shares are sold
- Holding period starts on grant date when 83(b) election was made
- After shares vest and are later sold, a short or long-term capital gain/loss is calculated using the original basis and value of stock when sold
- Total tax paid estimate: ($500 * 35%) + ($5,500 * 20%) = $1,275.
Should you make an 83(b) election?
As one might expect, there are a number of pros and cons for investors to weigh when considering making an 83(b) tax election.
Some of the advantages of making an 83(b) election include:
- Potential to reduce your overall tax liability. All else equal, it’s best to skew as much of the spread towards long-term capital gains instead of regular income. In 2023, the highest long-term capital gains tax rate is 20% vs the highest marginal tax bracket of 37%.
- More control over increases to your ordinary income. Adjusted gross income (AGI) and modified adjusted gross income (MAGI) are important in your tax situation. It determines the tax deductions/credits, marginal tax rate, the 3.8% net investment income tax, eligibility for tax-deductible contributions to a traditional IRA, Roth IRA eligibility, etc.. Because the FMV and purchase price at grant are known inputs, before making an 83(b) election, work with your CPA to assess the impact or get comfortable with losing control of it later.
- Potential to avoid ordinary income taxation altogether. This happens when there’s no spread to include in ordinary income. It’s still not riskless. You must still pay for the shares out of pocket and risk forfeiting the award if vesting requirements aren’t met. There’s also a potential the stock doesn’t appreciate.
- Start your long-term holding period early. With an 83(b) election, the holding period to determine the nature of the capital gain (or loss) begins when the election is made, instead of at vesting. Assuming everything goes according to plan, it’s possible to sell the shares upon vesting for long-term capital gain treatment.
Drawbacks to making an 83(b) election:
- There’s no guarantee you’ll ever receive the shares. As discussed, making an 83(b) election does nothing to ensure you will vest or have a gain. If you are given the shares, the full amount is taxable income for the year. Generally, an 83(b) makes the most sense when the purchase price is very small and the taxable spread is near zero.
- Risk of overpaying for the stock…and your tax liability. The stock market is notoriously volatile, and single stocks pose the greatest risk. If the share price at vesting falls below the FMV at grant, making the 83(b) election will backfire, as you paid tax on a larger spread (all else equal). If the stock price is also below your purchase price at vesting, you can either sell for a loss or sold it in hopes it will one day recover. Stocks don’t only go up!
- Irrevocable and non-refundable. The 83(b) election is irrevocable and tax paid is non-refundable.
- Cash-intensive. Tax payments for an 83(b) election must be made from your savings. If the election isn’t made, you may have more liquidity options down the road if the company is public. Cashless and net exercises usually aren’t available in private companies, though sometimes a company will offer a loan which is outside the scope of this article. Statutory tax withholding may be insufficient, so it’s important to work closely with your tax advisor.
Stock compensation specialists
Darrow Wealth Management specializes in stock options and equity compensation. Especially for founders and early employees, restricted stock can provide a major liquidity event that transforms your financial life. To maximize the opportunity, it’s critical to get the right team of advisors in place before making irreversible decisions with your shares.
Schedule a call with a wealth advisor to discuss your situation.
Darrow Wealth Management does not provide tax or legal advice.
