Simplifying Restricted Stock – What You Should Know

Many companies offer restricted stock awards (RSAs) in their executive compensation packages to drive performance and attract and retain top talent. The challenge often lies in understanding the value and opportunities of these packages. Today we’ll discuss a very important but not-so-well-understood topic, the 83(b) election.

RSAs vs. RSUs

First, it’s important to note that the 83(b) election only applies to RSAs and not to restricted stock units (RSUs). RSAs represent an actual stock transfer, while RSUs are a promise to transfer stock once vesting conditions are met.

The 83(b) election allows you to pay tax based on the RSA’s fair market value at the grant date instead of down the road when it vests. If no such election is made, you are subject to ordinary income tax at vesting. The election must be filed with the Internal Revenue Service no later than 30 days from the date of grant, so it’s critical to make the election in a timely fashion. If you miss that 30-day window, you’re out of luck.

When an 83(b) election makes sense

The goal of this strategy is to pay less tax now instead of more tax later when the stock may have increased in value. As with any strategy, however, the circumstances must be carefully considered.

Take this example: Say you were granted 100,000 shares at a value of $0.01/share when granted. If you make an 83(b) election, you pay ordinary tax on $1,000 (the grant value) now and nothing at the time of vesting. If you eventually sell the shares, you’ll pay tax on the sale at capital gains rates.

Now let’s say you do not make an 83(b) election, and the stock appreciates to $2/share at vesting. In this case, you will have $200,000 of ordinary income subject to tax at vesting, plus capital gains tax on any gains from that point forward if you eventually sell the shares.

When it doesn’t

If the grant value is larger, the decision becomes more difficult. You should carefully consider the potential risks before making this election. For example, what if the grant value in the above example is $100,000? Assuming a 37% rate, you are now looking at a $37,000 tax bill to make the election.

Here, you not only have to come up with the funds to pay the tax, but if the company fails or the stock value drops, you could have paid that tax on something that is now potentially worthless.

Another risk is if the stock doesn’t vest. This could happen if your employment terminates before vesting—and there is no deduction allowed for the income you recognized by making the 83(b) election.

Consider the 83(b) election carefully

With rare exceptions, the election is irrevocable. It’s important to carefully balance how much the tax hit will be now versus what you might be able to save later and how much risk you are willing to accept. 

The risks include not only the future performance of the shares and your vesting status but also the potential for adverse tax law changes in the future. When you make the election, you are opting to pay tax on ordinary income today rather than capital gain treatment later when the stock is sold. But if capital gain rates increase in the future, you may not save as much or possibly nothing at all. Don’t forget state taxes as well. It’s important to run the numbers.

It’s also wise to understand the impact on your complete financial picture. Running “what-if” financial planning scenarios, where you can see how much risk you need to take to reach your goals, can help you make the right call. These decisions are never easy, and we recommend reaching out to your Wealth Advisor for assistance.