Making a § 83(b) election for restricted stock can be a complex decision due to the inherent risks involved. It is best to get the advice of legal and tax counsel before making this decision. The election deals with property subject to a substantial risk of forfeiture. The reason its so popular for founders of a startup, is accepting shares of restricted stock can signal to investors that the founders believe in the company’s future success and are willing to put in some time for that to happen.
While it is not necessary to file a § 83(b) election, doing so means that the restricted stock will be taxed at the time it is granted and not as it vests over time. Doing nothing means that the shares will be taxed as income as they vest.
What is Restricted Stock?
What is the difference between restricted stock and authorized stock? Authorized stock is the total amount of shares authorized at the formation of a company, but not all shares need to be issued. Restricted stock is a type of unissued stock that companies may award for employee or other equity compensation purposes.
Shares of restricted stock do not vest immediately. Restricted stock is issued with a condition imposed on when the shares vest. Generally accompanied by a standard vesting schedule. That is to say, the ownership rights in the shares do not fully transfer until some future occurrence or fulfillment of the condition.
The vesting of the shares can be tied to performance or to a length of time. For instance, in a startup the purpose behind restricted stock can be to incentivize founders to continue with the company and help build it for a length of time after which their shares will vest. For executive compensation models, vesting of shares could be contingent upon meeting company goals and growth benchmarks.
Understanding Section 83(b)
Section 83 of the Internal Revenue Code concerns property transferred in connection with performance of services. Through § 83(b), property granted with an imposed condition or restriction can be taxed before it vests.
For restricted stock then, an employee (or founder) can choose to be taxed on the excess of its fair market value at the time it was granted. Under § 83(b) it must be included as gross income for the taxable year in which the shares of restricted stock were granted.
The benefit here is that the tax would be lower since the shares would initially have a lower valuation as opposed to later if the shares appreciate in value as the company grows. Also, once the stock does vest it will not be taxed again as income once the § 83(b) election has already been made.
However, the downside to § 83(b) is having already paid taxes on shares that are unvested. If the condition has not been met by the time a person’s services are terminated with the company, then the unvested shares must be forfeited. While the company will buy back the stock for the original purchase amount, the person cannot seek a refund on the amount they were taxed on the unvested shares nor can it be deducted as a loss. Another drawback here is the off chance that the vested stock’s value happens to be lower than its valuation at the time of the § 83(b) filing, thus being taxed more on less income.
Lastly, keep in mind that the deadline for making a § 83(b) election is pretty strict and it must be timely filed within 30-days of when the stock is granted. No exceptions!