As the annual grant season approaches, it is worthwhile to look out for whether restricted stock is part of your equity compensation benefits. While restricted stock is not the most common way that equity is granted, it does exist. (Also, be sure not to confuse restricted stock with restricted stock units (RSUs) — even though they are indeed very similar.)
Restricted stock is a transfer of company stock from employer to employee, just like RSUs. The major differentiator between restricted stock and RSUs is that you receive the shares of stock at grant as actual ownership with conditions. The shares vest over time, and you can eventually sell them. Restricted stock is taxed at vesting as ordinary income unless you choose a Section 83(b) election.
So, what is a Section 83(b) election? Why do so few people decide to use this seemingly tax-favorable election when receiving shares of restricted stock? Here are a few key details to keep in mind:
1. Paying taxes at grant:
The Section 83(b) election allows you to pay taxes on your restricted stock at grant rather than at vesting. You have to make the election within 30 days of your grant date. Keep in mind that you have no access to the stock at grant. Even though you own the shares, you are not able to sell them until they vest. You are basically making a decision to pay ordinary taxes in advance. Why would you do this? Because you are very bullish on your company stock and believe that it will be higher at vesting than at grant, therefore saving you taxes in case that is what happens. This is, of course, hard to speculate; therefore, the election can be a risky choice.
2. The election can’t be rescinded:
Once you make a Section 83(b) election, it is locked in. You can’t cancel or change your mind. If the stock price is, in fact, lower at vesting than at grant, you will pay higher taxes unnecessarily. You also will have to make the tax payments from your own funds, as you can’t sell the shares until they vest.
3. Risk of losing your job:
If you leave the company that granted you the restricted stock or you lose your job, you can’t recover the taxes you paid. You automatically forfeit the grant before vesting in both of these cases. You don’t own the stock even though you paid taxes on the grant already; therefore, you are not able to take any deduction for your loss.
4. Stock price volatility can be risky:
As mentioned already, a Section 83(b) election is a great choice if the stock price ends up being significantly higher at vesting than at grant. If the stock price doesn’t appreciate or even drops between grant and vesting, you will end up paying higher taxes, or you potentially can sell the stock and write off the loss.
Based on this summary, it may seem that there are more reasons not to make a Section 83(b) election. However, even though there are risks involved, this strategy can be a good decision in certain cases. If you are granted various awards, including incentive and non-qualified stock options, increasing ordinary income tax liability can potentially lower your alternative minimum tax (AMT) liability, which makes it possible to exercise more incentive stock options with higher spreads.
Making a Section 83(b) election is a risky and complex decision, and there are multiple factors to consider. As always, be sure to consult a tax advisor before making any decisions around your equity compensation grants — and please don't hesitate to contact Freedom Trail Financial with any questions you may have.