How to manage the tax burden of your restricted stock awards

As corporate employees become more tenured and are promoted to senior level positions, they are more likely to receive higher amounts of non-cash compensation as part of their overall compensation package. Increasingly, this may include restricted stock shares as a percentage of an annual bonus payment for example. These types of awards require careful attention, especially with respect to potential tax implications. Restricted stock awards are subject to a vesting schedule before the employee actually controls the shares. Unlike a stock option which is the right to purchase stock, these are actual shares or units granted to the employee. There is no strike price or exercise involved.

A limited window to make a decision on taxes

Restricted stock may come in different forms, either as restricted stock awards (RSAs) or restricted stock units (RSUs). While very similar, there are some key differences between them.

Restricted Stock Award (RSA)	Equity shares of company stock (can be public or private) are awarded as additional compensation or as a bonus. Increments of stock will vest over time and many include voting and/or dividend rights. Funds are considered compensation when vested.
Restricted Stock Unit (RSU)	The employer provides the right to acquire company shares (not actual shares) based on meeting vesting requirements. These typically do not offer voting rights or access to dividends.

One other key difference between these two is that a special tax election is available on RSAs but not on RSUs. This option is known as an 83(b) election, which may provide valuable tax benefits depending on the specific situation. Here’s a deeper look:

• Within 30 days of a granted award, the employee has the option of making an 83(b) election, allowing payment of taxes on the stock based on the fair market value (FMV) of the shares upon receipt, rather than when shares vest in the future. This amount would be reported as compensation income to the employee.
• If the employee does not take action within this 30-day window no taxes are due until the shares vest. This amount would be considered compensation income upon vesting, taxed as ordinary income and subject to payroll taxes.
• An 83(b) election allows an employee to “lock in” the tax payment on the shares when they are initially granted. If there is subsequent appreciation in the shares from the time they were granted until the time they vest, this appreciation would be considered a long-term capital gain when the shares are sold. This may yield significant tax savings. However, the election triggers an immediate tax burden, rather than being able to wait until shares vest.
• There are some key risks in making an 83(b) election. First, if the shares decline in value by the time the shares vest, the employee is effectively paying early taxes on shares that are worth less when available to them. Also, there is the risk that the employee leaves the company before the shares vest. In this case the tax payment on those shares would be forfeited. The IRS does not offer any type of refund, deduction or tax credit in these cases. 

Consider this example:

• 30,000 restricted stock shares granted at $5 per share
• Shares vest annually (10,000 shares per year) over three years
• After they are granted, the shares increase in value
  • After year one, shares are valued at $10 per share
  • After year two, shares are valued at $15 per share
  • After year three, shares are valued at $20 per share

Option #1 – no 83(b) election

For Illustrative Purposes Only.

Option #2 – 83(b) election

Taxes on shares are triggered when shares are initially granted (30,000 shares at $5/share) which equals $150,000 in taxable compensation income

In this case the employee receiving RSAs has avoided $300,000 in taxable compensation income which would have been subject to federal income taxes, federal payroll taxes and potential state or local taxes. Because of an 83(b) election, when shares are sold, the increase in the value from the time the shares were granted, to when they vested ($300,000), would be treated as a long-term capital gain when shares are sold.

What if shares decline in value over the same period?

In the example above, making an 83(b) outcome generally resulted in a more favorable tax outcome. However, equity shares could also decrease in value after they are granted. Consider this scenario based on a similar example. Instead, hypothetical share price values are reversed as the shares decrease in value from the time of initial grant until full vesting.

• 30,000 restricted stock shares granted at $20 per share
• Shares vest annually (10,000 shares per year) over three years
• After they are granted, the shares increase in value
  • After year one, shares are valued at $15 per share
  • After year two, shares are valued at $10 per share
  • After year three, shares are valued at $5 per share

For Illustrative Purposes Only.

If an 83(b) election was elected in this scenario, the taxpayer would receive $600,000 in taxable compensation income when the shares were granted (30,000 shares at $20/share). Essentially, the 83(b) election has resulted in a significantly higher tax bill on shares that are worth much less when fully vested. If the employee opted to pay shares when vested each year, the total amount of taxable compensation income would have been $300,000 (instead of realizing twice that amount of income when making the 83(b) election). This is potential major drawback of making an 83(b) election.

Seek expert advice

Whether or not to make an 83(b) election requires through analysis. Key factors include the ability to cover the tax bill of those shares right now if electing 83(b), the potential growth or decline prospects of the shares from the time of grant until they vest and the probability of whether or not you will be still employed at the company when the shares vest.

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