Tax Implications of Restricted Stock

In recent years restricted stock has become a popular form of incentive compensation for executives and other key employees.  The stock in the company comes with certain restrictions on what can be done with it.  Usually there is a period of time that must pass before the employee is permitted to sell it.  Also, if the employee does not remain with the company for a specified period, the stock is forfeited.  In tax-speak these restrictions are known as a substantial risk of forfeiture, and there are tax implications with that.

The receipt of the stock is income that is treated as compensation and is therefore subject to tax.  However, because of the “substantial risk of forfeiture” the income recognition is normally deferred until the stock is no longer subject to the risks.  You then pay taxes at your ordinary income tax rate based on the stock’s fair market value (FMV) after the restrictions lapse.

But there is another way.  You can make what is known as a Section 83(b) election to recognize ordinary income at the time you receive the stock and before the restrictions lapse.  This election, which you must make within 30 days after receiving the stock, can be beneficial if the value of the stock at the grant date is negligible or the stock is likely to appreciate significantly before the lapse of the restrictions.  The best part of the election is that it allows you to convert the future appreciation from ordinary income to long-term capital gains income and defer that tax until the stock is sold.

There are some disadvantages of a Sec. 83(b) election.  You must pay the tax in the current year.  You will be paying tax on something without having received any cash (remember, it’s still stock that you can’t sell).  But if the company is in the earlier stages of development, then the value of the stock had that time should still be minimal and thus the tax liability should not be great.  The biggest risk of making the election is that the taxes you pay because of the election can’t be refunded if you eventually forfeit the stock or its value decreases.

If you’re awarded restricted stock before the end of 2012 and it’s looking like your tax rate will go up in the future, the benefits of a Sec. 83(b) election may be more likely to outweigh the potential disadvantages.  But there are many moving parts in making an 83(b) election, so be sure to discuss the full situation with your tax advisor.

Greg Tanner – is a Tax Principal at Wertz & Company, LLP, a Professional Services Firm located in Orange County, CA that specializes in working with entrepreneurs along their journey to success.