Restricted stock awards tax saving with 83(b) election
Let us talk about the 83(b) election for restricted stock and understand how an employee can save on taxes.
Did you know that regardless of the kind of compensation given out in a company, all benefits gained will eventually be taxed? This applies not only to your salary and bonuses, but also to stock compensation plans like restricted stock options.
Restricted Stocks and Restricted Stock Awards
Restricted stock awards are equity compensation offered to employees in a company. They are a grant of the company stock in which the recipient’s rights in the stock are restricted until the shares vest or the restrictions lapse. This restriction period is normally called the vesting period. As soon as the vesting requirements have been completed and met, the employee becomes the owner of the shares instantly and can either sell the shares or keep them as long as they want.
While the most common way to offer equity rewards to employees is stock options, restricted stocks and restricted stock awards are becoming popular alternatives. A stock option offers the employee the right to purchase a defined number of shares at a fixed price. In this case, the employee does not own the shares until they buy the shares.
With restricted stock, the story is different. The employee owns the shares from the day they are issued. But these stocks are “restricted” which means that the employee still has to earn them. The most common kind of restriction placed on restricted stock is time-based and they usually have a vesting schedule, with shares earned over time.
How are restricted stock awards taxed?
When we talk about restricted stock awards taxation, there are two kinds of taxes that need to be considered. One is the capital gains tax and the other is the ordinary income tax. The important thing that has to be noted here is that the capital gains tax is way lower than the income tax rate. Even though the tax process is complicated, knowing how the tax works can help employees save a lot.
Let us take an example to understand this better. Let’s say there is an employee named Emily who just joined a startup company that has only five employees, including herself. Since the startup does not have a lot of capital to pay high salaries, they decide to offer Emily with some restricted stock awards as a part of her package.
For her to own the shares outright, she had to pay for them on the grant date and wouldn’t need to pay income tax on something she already owns. This means that Emily would not have to pay any taxes on her RSAs until they vest and are sold, in which she would have to pay capital gains tax on the amount he earns from the sale. Let us understand this better with some numbers.
Assuming that the FMV when Emily purchases the shares at the grant date is $1, and she was offered 200 shares, she would need to pay $200 to buy the shares. As time passes and the share vest, the value of the shares has increased to $10, resulting in a taxable gain of $9 ($10-$1).
Just to be clear, any taxable gain that comes between the grant date and the vesting is subject to the ordinary income tax. As soon as the shares vest, Emily would own all the shares. She would also have to pay ordinary income tax on the taxable gain here. Now, if Emily decides to wait a little longer before she sells the shares, hoping that the price of the shares increase, any following gain between the day the shares vested and the day the shares are sold is subject to capital gains tax.
So, the main point here is that the employee would be paying tax when the shares vest and also when they are sold. In fact, the value of the shares can fall after they have vested. This means that if the employee sells the shares after the price has fallen, they would earn way less than what they paid for the shares and the tax on it. With the income tax on the shares already paid, the employee should not expect the IRS to refund the payment. They do not refund any tax, even if you are at a loss.
Fortunately, there is a solution to this. The IRS allows you to make a Section 83(b) election for your restricted stock.
Saving tax with Section 83(b)
The 83(b) election means that the employee has the choice to pay all the ordinary income tax upfront. But you must be wondering why anyone would want to pay taxes early? The main reason is that they would be paying lower overall tax.
In fact, the taxable gain can be close to zero if the employee makes an 83(b) election. And since they do not “gain” anything yet (that is if the employee pays for the RSAs, and is not given it for free or on a discount), they would not have to pay any ordinary income tax for the RSA holdings. But to be able to enjoy this benefit, the employee would have to file for this election within 30 days from the grant date.
Let us get back to Emily and see how much she would be paying as tax for the restricted stock awards. Since she pays $1 which is the FMV of the shares on the grant day, Emily’s taxable gains would be zero at that time. And if she files for the 83(b) election for her RSAs, she would be choosing the option to pay the ordinary tax upfront, which would be $0.
Now when the RSA shares vest (value of the shares reach to $10 per share), Emily would not have to pay any income tax as she elected to pay the tax upfront when granted the RSAs, and only capital gains tax when she sells. Let us assume that the value of the shares at the time she sells is $20 per share. In this case, she will have to pay the capital gains tax on $19 per share ($20 – $1), which would be $3,800. With a capital gains tax rate of 15%, Emil will have to pay $570 ($3,800 * 15%).
This is the best way out for her due to two reasons:
- The capital gains tax is much lower than the ordinary tax.
- She does not come across any risk of paying taxes on illiquid shares that cannot be sold.
But what if Emily did not make the 83(b) election, then how would the case be? Well, she would not have to pay anything when the shares are granted. But once the shares vest where each share price is at $10 per share (for 200 shares, it will be $2,000), she will have to pay the ordinary income tax on the amount $2,000. With an income tax rate at 30%, Emily will need to pay $600 ($2,000 * 30%). After this when she sells the shares at $20 for $4,000, the capital gain of $2,000 ($4,000-$2,000) would be taxed at 15% for a tax of $300. In short, she would have to pay a total tax of $900 for the RSAs offered if she did not make the 83(b) election.
Here is a summary of the transactions with and without the 83(b) election.
|Value||Cost with 83(b) election||Cost without 83(b) election|
|Grant Date||$200 (200*$1)||$200||$0|
|Vested Date||$2,000 (200*$10)||$0||$600|
|Sell Date||$4,000 (200*$20)||$570||$300|
|Ordinary Income||$0||$600 ($2,000 * 30%)|
|Capital Gain||$570 ($3,800 * 15%)||$300 ($2,000 * 15%)|
Section 83 (b) election with a Loss
Let’s assume that there is another employee named Amy who joins another company, and is offered 500 shares from the company. The share price at this time was at $5 per share. But in her case, the company decided to offer Amy the shares for free due to her extensive experience in her field. This means that Amy received shares worth $2,500 ($5 * 500 shares). Since she gets it for free, this amount is a taxable gain amount.
Now to avoid paying taxes later on, Amy decides to make the 83(b) election. This would mean that Amy would have to pay the ordinary income tax on the shares. With an ordinary income tax rate of 30%, she pays an upfront tax of $750 ($2,500 * 30%) when she is granted the RSAs. Now, let us assume that the company does not do well, and when the shares vest, the value drops to $1 per share.
This means that Amy would have shares worth $500. She would have lost as she paid a tax of $750 for shares that were worth $2,500 and whose worth was supposed to increase. And once the tax has been paid, regardless of if you are at a loss or gain, the IRS does not refund the payment. So, in this case, her choice to make the 83(b) election turns out to be wrong and costs her a lot more.
This brings up the question: How do we know if it is right to make the 83(b) election or not for restricted stock awards? Well, let us look at the downsides when making the election.
Downsides when making the 83(b) Election for Restricted Stock Awards
When you decide whether or not to make the 83(b) election for the restricted stock awards, keep in mind these important points, which include:
- Timing of tax payment: Since it is important for the employee to pay ordinary tax upfront once they make the 83(b) election, they would need to have the money ready for the tax withholding obligation. In fact, they can use the shares vested to cover the tax withholding obligation in this case, without removing anything from their pocket.
- Falling share prices: This is an obvious disadvantage. Let us say that the stock prices drop and the employee has already paid the tax upfront. In this case, they would have paid more taxes at the grant date than they could have during the vesting day. It becomes a huge loss for the employee where they would not be able to get a refund from the IRS.
- Risk of forfeiture: In case the restricted stock award is forfeited, where the employee is removed from the company or the company goes bankrupt and they had to leave, a loss cannot be claimed for tax purposes with respect to the RSAs.
Whatever you do, ensure that you keep track of all the transactions and shares in your company. Eqvista can help you with this. Eqvista is an advanced equity management software where founders can issue and track their company shares.
Not only that, they can also issue RSAs, RSUs, and other kinds of stocks all online through the platform. It is also very easy to create vesting schedules and apply them to your stock awards to know exactly when they vest. Eqvista will take care of the calculations after you fill in the details. Try out the application here today!