Stock Compensation: Understanding the 83(b) Election
Many companies offer stock as a form of compensation to employees. The award of equity interests can help companies attract talent, and also provide an incentive to motivate employees. Stock compensation often takes place in the form of either stock options or restricted stock. Upon vesting, stock options give employees the option to buy shares at a set price for a specific period of time. Restricted stock simply transfers to the employee once all of the restrictions lapse. Restricted stock is therefore becoming more common due to the simplicity for the employee and for the fact that there is no risk of an option being underwater if the stock price declines. When employees receive restricted stock or other restricted property in exchange for compensation, they may want to consider making a Section 83(b) election.
Understanding the 83(b) Election
In order to understand the 83(b) election, it is first important to understand the taxation of restricted compensation. Code Section 61 of the Internal Revenue Code states that compensation received for the performance of services is taxable. Code Section 83 of the Code states that property transferred in connection with the performance of services shall be taxable to the employee in the year in which the rights to the property are transferred to the employee. For example, if restricted stock is granted to an employee with a five year vesting period, the stock award would be taxable to the employee in year five, when the shares vest and are transferred to the employee. The amount of taxable income to the employee is computed on such date as the fair market value of the property (which in the case of stock would be the stock price on the date of vesting) over any amount paid by the employee for the property (which is often zero). This is taxed as ordinary income. The employee’s basis in the stock then becomes the fair market value on the date of vesting, and the holding period begins that date. Any gain or loss on the sale of the property after this date will be taxed as a capital gain or loss.
The Section 83(b) election accelerates the recognition of compensation income to the date on which the restricted property is granted. There would then be no income event when the restrictions lapse and the property transfers to the employee. The benefit of this election is that if the value of the property increases, the employee pays a smaller amount of tax today on a lesser amount of compensation income than they would pay if they had waited for the restrictions to lapse, when the value is higher. If the property significantly increases in value, this can be a very large savings. The potential downside of the election is that if the value of the property declines by the date that the restrictions lapse, then the employee will have ended up accelerating income and paying more tax now to get lesser value in the future. Another potential downside is that if the employee is forced to forfeit the property, he or she will have paid tax at ordinary income rates, and will only get a capital loss upon forfeiture.
In order to make the election, it must be in writing and must be sent to the IRS within 30 days of the grant of the restricted property. The employee must also provide a copy of the election to the employer. In addition, the employee must include a copy of the election with his or her income tax return for that year and pay the appropriate amount of tax due.
For more information on the Section 83(b) election, options compensation, its consequences for both employees and employers, or our services, please contact us at firstname.lastname@example.org or (212) 245-5900.
Eric Swerdlow, CPA, MST is a Tax Manager who has been with FF&F for 10 years. He specializes in corporate and partnership taxation, with a strong background in consolidated corporations, business planning, provisions for income tax, international operations, foreign tax credits, partnership basis step-up and special allocations, fixed assets, and capitalization. Eric’s focus industries include shipping, transportation, oil and gas services, energy, and manufacturing and wholesale.