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What to Know About an 83(b) Election for Restricted Stock

What to Know About an 83(b) Election for Restricted Stock

Employee stock grants can be an excellent benefit, but they can also be complicated, especially when they involve restrictions and vesting schedules. Stock grants also come with significant tax consequences that, depending on the situation, can leave you with large tax bills. However, you do have some control over when those tax bills are paid and, in the right circumstances, you can lower your total tax bill significantly if you elect to pay taxes upfront. That’s where the 83(b) election comes in.

When a company awards an employee restricted stock, the employee is taxed on the difference between what they paid for the stock and the fair market value of the stock. For example, if an employee is awarded stock worth $10 and the employee paid $8 for the stock, the employee is taxed on the difference of $2. Typically, the employee isn’t taxed on that $2 until they actually become vested in the stock. Until then, the stock is at substantial risk of forfeiture because if they leave the company for any reason, they won’t receive the stock.

Basics of an 83(b) election

With an 83(b) election, you are electing to pay taxes on the entire value of the stock on the date of grant instead of paying taxes as you become vested in the stock. You pay taxes based on the current value as opposed to whatever the value happens to be when you become vested. 

For example, you are awarded 10,000 shares of company stock that vest over 5 years. The current share price is $1. If you make the 83(b) election you will include $10,000 in your ordinary income the year you are granted the stock and you will be taxed at your marginal tax rate. This could be up to 40% which means $4,000 in taxes for those in the higher tax brackets. If you don’t make the 83(b) election, you will include in your ordinary income each year the portion that vests that year. The example below assumes 20% vesting each year and 40% tax withholding.

Stock Price Vested Value  Taxes Due 
Grant $1.00  $                    –    $                –   
Year 1 $1.50  $         3,000.00  $      1,200.00 
Year 2 $2.00  $         4,000.00  $      1,600.00 
Year 3 $2.50  $         5,000.00  $      2,000.00 
Year 4 $3.00  $         6,000.00  $      2,400.00 
Year 5 $3.50  $         7,000.00  $      2,800.00 

 

What are the benefits of making the 83(b) election?

In the example above, if you made the election, you would have paid $4,000 in taxes at the date of grant. If you didn’t make the election, you would end up paying $10,000 over 5 years. The more the stock price goes up, the more money you save on taxes by making the 83(b) election.

What are the risks of making the 83(b) election?

If you leave the company before you are fully vested in the stock, it’s possible you will have paid taxes on stock that you don’t ultimately receive. In the above example, if you left after 2 years you would have overpaid by $1,200; however, if you stayed at least through year 3 you would come out with tax savings.

If the stock price declines you would also end up overpaying on taxes. 

When would I want to make an 83(b) election?

    • You plan on staying at the company until your shares are fully vested; 
    • You have the cash to pay the taxes due within 30 days of your stock grant; 
    • You are confident that the value of the stock is going to go up;
    • Adding the vesting value to your income each year would; consistently make you ineligible for tax credits that you would otherwise be eligible for;
    • Your tax bracket will be the same or higher in future years.

When wouldn’t I want to make an 83(b) election?

    • You plan on leaving the company before the stock is fully vested;
    • You don’t have enough liquid assets or it would strain your finances to pay the taxes upfront;
    • You think the stock value will go down or stay the same; or
    • You will be in a lower tax bracket in the year(s) the shares vest.

What happens when I sell the stock?

You will pay the favorable capital gains tax rate (20% + 3.8% for high-income taxpayers) on any amount that exceeds your cost basis.

If you make the 83(b) election, the cost basis in our example would be $1 per share because that is the amount you included in your income. If you sold all your shares in year 5 after becoming fully vested you would have a capital gain of $25,000. ($35,000 sale price – $10,000 cost basis)

If you do not make the 83(b) election, the cost basis of your shares would vary based on the price of the stock as it vested. You would have a total capital gain of $10,000.

# of Shares Cost Basis Capital Gain
Year 1 2000 $         3,000.00  $      4,000.00 
Year 2 2000 $         4,000.00  $      3,000.00 
Year 3 2000 $         5,000.00  $      2,000.00 
Year 4 2000 $         6,000.00  $      1,000.00 
Year 5 2000 $         7,000.00  $                 –   

Your total taxes paid after the sale of all shares:

83(b) election No 83(b) election
Ordinary Income (40% tax rate) $         10,000  $           25,000 
Capital Gains (23.8% tax rate) $         25,000  $           10,000 
Total Taxes Paid $           9,950  $           12,380 

Bottom Line:

An 83(b) election can be an effective tool to potentially lower your overall tax liability on employee stock grants; however, there are many factors that go into determining if it’s the right choice for you. How a company sets up its stock plans and each employee’s situation can vastly impact these numbers and introduce other considerations that might make an 83(b) more or less appealing.  As financial professionals, it’s our job to help guide you through the options and determine the best course of action for you and your unique situation.

AUTHOR

Alicia Vande Ven, M.S.

Alicia Vande Ven, M.S.

Candidate for CFP® Certification

Alicia Vande Ven is a Candidate for CFP® Certification at Walkner Condon Financial Advisors, a fee-only, fiduciary financial advisor firm based in Madison, WI, that works with clients locally and around the country.

Six Things to Know about Employee Stock Options

Six Things to Know about Employee Stock Options

Employee stock options can be a valuable part of a compensation package. They can also be misunderstood. Here is a quick guide to walk through some of the common questions that we get from clients and prospective clients regarding employee stock options, as well as some additional items to consider. 

There is the possibility you found this blog by searching “employee stock options,” but you may not have options at all (more on that later). There is also a reasonable chance that you do, in fact, have employee stock options available to you (hence why you conducted the Google search in the first place). So, let’s define employee stock options. 

TYPES OF EMPLOYEE STOCK OPTIONS

Investopedia defines employee stock options as “a type of equity compensation granted by companies to their employees and executives.” They are considered derivatives because the value of a stock option is derived from the price of the underlying stock. If you own a stock option you do not own the actual stock itself. Rather, you have the right to buy the stock at a predetermined price (the strike price). If the price of the actual stock is greater than the strike price, the option is considered “in the money”. Of course, you’d rather have an option that is in the money than out of the money; an out-of-the-money option is worthless! There are two main types of employee stock options: Incentive Stock Options (ISOs) and Nonqualified Stock Options (NSOs, or sometimes you’ll see NQSOs). They are treated differently than standardized options contracts that trade on an exchange. Standardized options contracts are similar in that they may give someone the right to buy (or sell) a stock at the strike price, but anyone can own them (you don’t have to be an employee of the company). Investors can buy or sell standardized options contracts to hedge risk, generate income, or use them speculatively.

ISOs and NSOs are similar in that they give the employee the right to buy the stock at the strike price. They are also both subject to a vesting schedule. Once options vest, the employee can exercise the option. For example, let’s say an employee is awarded 1,000 options (either ISOs or NSOs) that vest over a four-year period. Assuming that they are still with the company and have met the criteria outlined in the stock award’s plan document, the employee vests 25% after one year passes. They are then able to exercise 250 options (i.e. they buy the stock at the strike price). If the strike price of the stock is $50, the employee can purchase 250 shares for $12,500. This could be a good deal if the market price of the stock is $100/share! However, the option doesn’t have value when the market price of the stock is $25, for example (why would you want to buy a stock for $50 when it is worth $25?).

Before diving into the rest of this blog, I want to remind you that, although taxation is discussed at a high level, I am not a legal tax advisor! Taxes, especially around the various forms of equity compensation, get complicated. That is why there are good tax advisors and CPAs out there! Please remember that this blog is NOT exhaustive and that it makes sense to work with a financial planner alongside your tax advisor/accountant. Let’s continue. 

TAXATION OF EMPLOYEE STOCK OPTIONS

The big difference between ISOs and NSOs is taxation. Generally, ISOs are more favorable from a tax perspective. ISOs may not be taxable when exercised, whereas the difference between the fair market value and exercise price of an NSOs will be subject to ordinary income tax. Note that exercising your ISOs may trigger the Alternative Minimum Tax (AMT). The AMT is essentially a tax code that runs parallel to the federal income tax code. The purpose of the AMT is to ensure that taxpayers with the tools and resources to greatly reduce their tax bill through deductions etc. still have to pay a minimum tax. Most U.S. taxpayers are not subject to the AMT. Your tax preparer will compare your tax liability that is shown on your “normal” tax return (IRS Form 1040) to the tax liability calculated from the AMT, and the taxpayer will have to pay the higher amount. 

Without going too far down the AMT rabbit hole, let’s get back to ISO and NSO taxation. There is also a difference in how ISOs and NSOs are treated when the underlying stock is sold. ISOs may provide the opportunity to have a larger share of the gain subject to capital gains tax, compared to NSOs. In the case of the ISO, the difference between the sale price and the exercise price could be subject to capital gains rates. Compare that to the NSO, where the difference between the sale price and the fair market value price on the exercise date could be subject to capital gains rates (all else equal, a smaller portion than the ISO). Why is this important? In most cases, the long-term capital gains rates are lower than the ordinary income tax bracket. For example, someone in the 37% ordinary income tax bracket would be in the 20% long-term capital gains tax bracket (well, it could be 23.8%: 20% capital gains tax + 3.8% net investment income tax). I don’t know about you, but I’d rather have most of my gain generated from my ISOs be taxed at 20% (or 23.8%) rather than 37%! It is also worth noting that depending on the state that you live in, there may be a capital gains tax at the state level in addition to federal taxes. To qualify for the more favorable long-term capital gains rate upon disposing of stock obtained from exercising an ISO, one must hold the stock over one year from the exercise date and over two years from the stock option grant date.

PRIVATE COMPANY VS. PUBLICLY TRADED

How does this change if a company is privately held, compared to a publicly-traded company? In the case of a publicly-traded company, the market value of the stock is pretty easy to determine. Not necessarily the case for a private company. Here in Madison, Wisconsin, there are a lot of people that work for Exact Sciences (publicly traded: EXAS) as well as Epic Systems (private). Both companies have robust equity compensation plans. It is quite easy to find the price of EXAS stock, just ask Siri (she’ll tell you!). On the other hand, try asking Siri to provide you with the price of a share of Epic Systems. Spoiler alert: I tried this, and she will politely respond, “I don’t see the stock ‘Epic Systems’”. Ultimately, Epic obtains an annual assessment of the price of a share of their stock that is approved by the Board of Directors. Disposing of the shares will also be treated differently between a public and private company. If you obtain stock from an employee stock option or another form of equity compensation (assuming fully vested and no remaining restrictions), you can probably sell the stock to any buyer on the open market. With private companies, disposing of the stock typically means that you sell the vested shares back to the company. The stock plan document will describe the logistics of how the transaction occurs. If you sell the stock back to the company, the transaction is subject to capital gains. Taxation of Restricted Stock or a stock option of a private company is typically treated the same as it would a publicly-traded company; however, as always, this is a topic that should be run by your tax advisor.

OTHER FORMS OF EQUITY COMPENSATION

You might be wondering, what about my RSUs, ESPP, SARs, or other flavors of equity compensation that I have through my employer? A trend that we see within the world of equity compensation is an uptick in Restricted Stock Unit (RSU) awards. An RSU isn’t a direct share of the underlying stock. Rather, the delivery of shares of stock occurs after the RSUs vest. An RSU is granted to an employee and is usually subject to a three or four-year vesting schedule. Taxation occurs, at ordinary income rates, when the RSUs vest and the stock is delivered. Once you own the vested stock, taxation is treated just like any other stock: It depends on 1) the holding period (if it is greater than one year or not) and 2) if the stock is sold at a gain or loss. Employee stock options still exist, of course, but RSUs have become more popular since they usually have some value – unless the company stock goes to $0. In the case of ISOs and NSOs, if the options are out of the money, there is no value (technically there might be some “time value,” which is the concept that an option has more value the further away it is from its expiration date). I’ll leave it to Bill Gates to describe it in a way that I couldn’t do better myself: 

“When you win [with options], you win the lottery. And when you don’t win, you still want it. The fact is that the variation in the value of an option is just too great. I can imagine an employee going home at night and considering two wildly different possibilities with his compensation program. Either he can buy six summer homes or no summer homes. Either he can send his kids to college 50 times, or no times. The variation is huge; much greater than most employees have an appetite for. And so as soon as they saw that options could go both ways, we proposed an economic equivalent. So what we do now is give shares, not options.”

I’ve had many conversations with people and they find themselves using the terms “Restricted Stock” and RSUs synonymously. Restricted Stock (RS) is different from an RSU! Restricted stock is company stock that is granted to you but you have voting rights and the right to dividends during the vesting period. That is not the case with RSUs. From a taxation perspective, the big difference between RS and RSUs is that the RS has the option to make an 83(b) election. If an employee has RS, the 83(b) election allows the employee to be taxed on the grant date, instead of the default of being taxed at vesting. The 83(b) election might make sense when the employee strongly believes that the price of the stock will increase over time. The thought process is that they would rather get taxed on the grant date when the value of the stock is, say $1000, opposed to when the stock vests when its value is $2000, for example. An 83(b) election is risky. There is a chance that one makes the 83(b) election and is taxed on an amount that is higher than the value when the stock vests or is sold at a later date. In that case, the employee overpaid taxes, and cannot get refunded for the overpayment. Therefore, if the employee thinks that the stock price might go down, they might not want to utilize the 83(b) election. Ultimately they should engage with their tax advisor to take into consideration all other tax-related factors in their decision.

Employee Stock Purchase Plans (ESPP) are also quite common. These plans allow employees to purchase company stock with funds deducted directly from their paycheck, usually at a discount (up to 15%). In the case of an ESPP that has a 15% discount, if the fair market value of the stock is $100 (as defined by the plan document), the employee has the opportunity to buy the stock at $85. Taxation upon sale of stock acquired from an ESPP can be a combination of ordinary compensation income and capital gains. The amount of time that you hold the stock from the offering period (when money is deducted from your paycheck) and the purchase period (when the actual stock is purchased) will determine the type and extent of taxation. ESPP taxation is similar to the tax treatment of ISOs, from the perspective of a qualified disposition (generally favorable tax treatment) vs. a disqualifying disposition (generally not as favorable). 

Stock Appreciation Rights (SARs) are another form of equity compensation. We still see SARs, but in our experience much less than RSUs or traditional employee stock options (ISOs & NSOs). With SARs, an employee can profit when the stock appreciates, just like the name implies. Depending on how the plan is set up, the employee can be paid in cash or company stock (taxed as ordinary income upon exercise, regardless if you receive cash or stock). Note that the SAR must be exercised! The payout doesn’t occur automatically when the price of the underlying stock appreciates. Similar to employee stock options like ISOs and NSOs, SARs may have no value, in the case where the stock never appreciates after the SARs were granted. The “gain” (fair market price of the stock minus exercise price) is taxed as ordinary income upon exercise.

WITHHOLDING

As you can see, a taxable event may occur at different stages of the game, depending on what type of equity compensation we are talking about. Many wonder, will I have to pay taxes out-of-pocket? In most cases, you will be able to withhold an amount to account for the tax due from a taxable event. Depending on the type of plan you have, there could be multiple options when it comes to withholding. This is another area where a good review of the plan document will tell you your options. 

In some cases where the employee receives cash (e.g. exercise of a SAR where they get their payout in cash instead of shares of stock), the company may simply withhold taxes in the form of cash, similar to withholding from your paycheck. They will withhold for federal & state income tax, Social Security, and Medicare. In a case where the employee is receiving stock (e.g. RSU vests, shares of company stock are delivered to the employee’s brokerage account), the company may withhold the appropriate amount in the form of shares. In that case, the employee receives an amount of shares net of withholding (I’ve also seen it described as “surrendering” shares). By withholding shares, it allows the employee to avoid paying the withholding with cash. Note that just because taxes are withheld doesn’t mean that a taxpayer won’t have to pay anything out of pocket! In other words, there are cases where the tax withheld was too little, and the taxpayer still owes a portion of their tax liability by the time they file their taxes. 

RISKS

Investing comes with risk, although not all risks are equal. Obvious statement ahead, but people participating in the many types of employee stock plans mentioned above want the price of their company stock to go up! However, we know that stocks don’t increase exponentially (or linearly, for that matter) into perpetuity. They can be volatile and in some cases can lose significant value. As discussed earlier, in the case of employee stock options like ISOs and NSOs, forms of equity compensation can lose all of their value. Think back to the Bill Gates quote above. All in all, equity compensation plans can provide a unique opportunity for you to save, invest, and grow your net worth. It doesn’t always work out exactly as planned, but if managed appropriately, equity compensation plans can provide an excellent supplement to help you meet your financial goals in a tax-advantaged way. 

 

Mitch DeWitt, CFP®, MBA