Tax planning and compliance for investors
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By Kaye A. Thomas
Updated August 31, 2015
An explanation of when and how you make the section 83b election.
As explained below, the tax rules for restricted stock provide both an advantage and a disadvantage when compared to the rules for vested stock. If you don't like the trade-off, you can make the section 83b election. When you do, you'll be treated (mostly) as if you received vested stock. But you have to act fast: the election must be made within 30 days after you receive the stock.
Need a book? Our bestselling book Consider Your Options provides a plain language guide to getting the most from stock options, employee stock purchase plans, restricted stock awards and other forms of equity compensation. Our other book on this topic, Equity Compensation Strategies, is a reference and study guide for professionals who advise clients on how to handle stock options.
To get the most out of this page, you need to be familiar with the terminology and rules for receiving vested stock and restricted stock from an employer. If you're not already familiar with those rules, see the following pages:
You don't have to report income when you receive restricted stock from an employer. That's the good news.
The bad news is that you have to report income when the stock vests, even if you don't sell it at that time. What's worse, the income you report includes any increase in the value of the stock during the vesting period. You have to report the full value as compensation income, not capital gain.
Example: In return for services, you receive 4,000 shares of restricted stock in a startup company when the shares are worth $1.25. Shortly thereafter the company goes public and is hugely successful. When the shares vest two years later they're trading at $50.
In this scenario you report nothing when you receive the shares, but report $200,000 of compensation income (not capital gain) when the shares vest. You may have to pay as much as $70,000 in federal income tax, even if you haven't sold the shares.
If you make the section 83b election, the rule described above doesn't apply. You pay tax when you receive the stock, but not when it vests. You'll also report capital gain or loss when you sell the stock.
In the example above, you would report $5,000 of compensation income when you make the election — a far cry from $200,000! You have nothing to report when the stock vests. If you sell for $200,000 after holding the stock more than a year you'll report $195,000 of long-term capital gain, perhaps paying less than half the amount of federal income tax that would apply without the election. By volunteering to pay tax on $5,000 in the year you received the stock, you reduced your overall tax liability by tens of thousands of dollars.
Stock, not options: Many option holders, seeing the beneficial effect the election can have, wonder if they can make the election when they receive nonqualified options. Unfortunately, the answer is no. These rules treat you as if you didn't receive any property until you exercise the option and acquire stock.
The section 83b election doesn't always work out this well. If the stock doesn't rise in value after you make the election, you've accelerated tax (paid it sooner) without receiving any benefit.
Worse, you might forfeit the stock after making the election. In this case you would deduct any amount you actually paid for the stock (subject to capital loss limitations) but you get no deduction relative to the compensation income you reported when you made the election. That's a miserable result: the election caused you to pay tax on income you didn't get to keep, with no offsetting tax benefit later on.
The section 83b election makes sense in the following situations:
Conversely, you should avoid the section 83b election where a forfeiture seems likely, or where you'll pay a great deal of tax at the time of the election with only modest prospects for growth in the value of the stock.
Don't miss this chance: Sometimes an employee pays full value for stock in the company, but has to accept a risk of forfeiture. The way this usually works is the employee agrees to sell the stock back for the amount he paid to buy it if he quits within a specified period. This is a "risk of forfeiture" even though the employee won't lose his original investment because he can lose part of the value of his stock if employment terminates before a specified date. As a result, the employee will recognize income when the stock vests. You can avoid this result by making the section 83b election. And it's free. The election costs nothing because the amount of income you report is the value of the stock minus the amount you paid, and that's zero. Failure to make this free election can be a costly mistake.
There's no special form to use in making the election. You simply put the appropriate information on a piece of paper and send copies to the right people. Although there is no required form, it probably makes sense to follow the format of the sample election published by the IRS.
The key point about filing the election has already been mentioned: it has to be made within 30 days after you receive the property. If you don't act within that time you're out of luck. Here's what you need to do:
Change in rules: Taxpayers were previously required to attach a copy of the election to their income tax returns. For transfers on or after January 1, 2015 this is no longer necessary.
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