Section 83(b) considerations for employees receiving stock compensation

Overview of stock compensation

Generally, individuals are cash-basis taxpayers who report compensation as ordinary income in the year of receipt. However, when employers pay employees (or other service providers, such as contractors or directors) with property, including stock, rather than cash, special rules under section 83 apply to these payments. Although this summary is applicable to a variety of service providers and service recipients, the terms ‘employer’ and ‘employee’ will be used throughout.

A key advantage of paying employees with company stock is that at least a portion of the employee’s compensation is tied to company performance, which incentivizes the employee to help increase company value. The relationship between company performance and the employee’s compensation can be more significant when the alignment spans more than one year. For example, if the company grants restricted stock to the employee but provides that the employee’s interest in the stock will only become vested if the employee is still with the company at the end of three years, the company motivates the employee to both maximize company value and continue with the company for an extended period of time.

There are various forms of stock compensation that an employer may use to incentivize key employees. This article focuses on restricted stock grants. For tax consequences of stock options, see Frequently asked questions about stock options.

Tax consequences of restricted stock

When stock transfers are subject to such vesting conditions (i.e., restrictions), the value of the stock is generally not taxable to the employee until those conditions are satisfied. When conditions are met, the value of the stock is taxed as ordinary income. If all has gone as planned, the stock value on that future date will be higher than the value on the date the stock was originally transferred to the employee subject to the vesting conditions.

A section 83(b) election allows the employee to elect (within 30 days of receiving the restricted stock) to include the value of the stock in income currently at its grant date value despite the fact that the rights to the stock have not yet vested. Making the election also starts the employee’s holding period in the stock for capital gain tax purposes. Basically, the employee is treated as owning the stock for tax purposes even though he or she must still satisfy the associated vesting conditions before possessing a non-forfeitable right to the stock. For tax purposes, the election converts any appreciation in the stock from the date of grant through the future vesting date from ordinary income into capital gains. This occurs because the stock is a capital asset and the employee, by making the election, is deemed to have owned the stock from the date of grant even though the stock was forfeitable until the vesting conditions were satisfied.

Stock compensation eligible for section 83(b) elections

For the tax consequences described to apply, stock has to be transferred to an employee subject to a substantial risk of forfeiture (typically referred to as vesting). Generally, this substantial risk of forfeiture is connected to either a certain period of future services or a particular performance metric, or both. If the stipulated time period or performance metric is not met, the employee will forfeit the stock back to the employer for no consideration. The fact that the value of the stock may decline is not a substantial risk of forfeiture.

Sometimes employers require the vesting conditions to be met before the stock is transferred to the employee. This is called a restricted stock unit (RSU) or performance stock unit (PSU), depending on what the vesting conditions were. Because these conditions must be met before the shares are transferred, RSUs and PSUs result in vested shares being transferred so there is no availability of an 83(b) election. The RSU and PSU itself is considered a promise to pay something in the future instead of property when it is granted.

Similarly, stock options typically require vesting and exercise to occur before shares are delivered. Thus, an 83(b) election is not available for stock options because the option itself is not considered property and upon exercise, the employee receives vested stock. Early exercise options may make an 83(b) election available, but the employee would be making the election on the unvested stock received upon exercise, not on the option itself.

Impact of making an 83(b) election

Consider this example. On July 1, Year 1, ABC Company grants its CFO 100 unvested shares of ABC Company stock with a current value of $100 per share and stipulates that if the CFO continues their employment until July 1, Year 5, the shares will vest and become non-forfeitable. If, however, the CFO’s employment is terminated prior to July 1, Year 5, the stock must be forfeited back to ABC Company.

Under the general tax rules, if the CFO continues employment until July 1, Year 5, the value of the stock on July 1, 2028, will be taxable to the CFO in 2028 as ordinary income.

However, if the CFO makes a section 83(b) election, the $10,000 value of the stock on July 1, Year 1, will be taxable to them in Year 1 as compensation subject to ordinary income tax rates. If the stock appreciates to $150 per share on July 1, Year 5 (for a total value of $15,000), the election will result in the CFO accelerating the recognition of the $10,000 of ordinary income by five years but converting the tax treatment of the $5,000 of appreciation in the stock from Year 1 to Year 5 from ordinary income tax to capital gain, which will not be taxable until the CFO disposes of the stock.

The risk to the CFO of making a section 83(b) election and reporting the income during Year 1 is that if their employment is terminated before July 1, Year 5, and they must forfeit the stock back to ABC, they are not entitled to a tax deduction for the $10,000 of income reported, or the tax paid, in the earlier year. If the CFO had to pay an amount to acquire the stock, they may have unrecovered basis in the stock that results in a capital loss, but the ordinary income reported on account of the section 83(b) election is not allowed to be treated as basis.

If the CFO in the example believed they would likely not remain employed by ABC Company for the next five years, a section 83(b) election would not make sense because the CFO would be paying tax on income that they would likely not ever receive.

Factors to consider before making an 83(b) election

An individual must try to predict the future when deciding whether or not to make a section 83(b) election. If the prediction is correct, the appreciation from the grant date to the vesting date will be converted from ordinary income to capital gain, but if the prediction is wrong, the individual will end up paying tax on income that he or she would not otherwise have been required to report, with no opportunity to recoup the tax paid or otherwise deduct the income reported previously.

A number of factors should be assessed when a section 83(b) election is available. The expected amount of appreciation in the stock is one consideration, because the more appreciation that is expected, the greater the amount of tax savings that can be realized from converting ordinary income to capital gains. The current value of the stock is also something to consider as a very low current fair market value also reduces the income reportable with the election and thus the tax risk is also diminished, with bigger potential savings if the stock value increases substantially. The likelihood of the vesting conditions being met is another consideration. If the CFO in the example believed he likely would not remain employed by ABC Company for the next five years, a section 83(b) election would not make sense because he would be paying tax on income that he likely would not ever receive. The possibility of tax legislation that might change the differential in tax rates between ordinary income and capital gain is yet another factor to consider. The current rate differential makes the election attractive, but if the rate differential were smaller, the risk associated with making the election may not be worth the potential tax savings. In addition, since the restricted property is not liquid and will not provide a source of immediate cash, the employee must also evaluate whether funds are available to pay any resulting income tax in the year of the election.

How to file an 83(b) election

If an employee decides to make a section 83(b) election, the individual must file a statement with the IRS within 30 days from the transfer of the property for the election to be valid. The employee must also notify the employer of the election so the employer can properly report the compensation in that period and withhold the necessary income and payroll taxes. From the employer’s perspective, reporting the value of the stock as current compensation allows the employer to take a corresponding tax deduction.

The election can be completed via a statement to the IRS including certain required information on the taxpayer and the property received, or filed on Form 15620. If the taxpayer does not use Form 15620, the election statement is mailed to the IRS. The IRS does accept electronic signatures on either of these methods.

If a taxpayer uses Form 15620, the form can be mailed to the IRS or filed electronically. To file electronically, taxpayers would choose Form 15620 on the IRS mobile-friendly forms page, and log in through an ID.me account to submit the form.

Given the numerous factors above that should be considered before making an 83(b) election, it is recommended to consult with a tax advisor before filing the election. In addition, the election is irrevocable and, thus, there is generally no relief for missing the 30 day filing window.