It is common for employees to receive stock-based compensation from their employer as part of their compensation and benefits package. However, the tax consequences of such compensation can be complex — subject to ordinary-income, capital gains, employment and other taxes. On the other hand, if you receive restricted stock awards, you might have a tax-saving opportunity in the form of the Section 83(b) election.
Converting ordinary income to long-term capital gains
Restricted stock is stock your employer grants you subject to a substantial risk of forfeiture. Income recognition is normally deferred until the stock is no longer subject to that risk (that is, it’s vested) or you sell it.
At that time, you pay taxes on the stock’s fair market value (FMV) at your ordinary-income rate. The FMV will be considered Federal Insurance Contributions Act (FICA) tax income, so it also could trigger or increase your exposure to the additional 0.9% Medicare tax.
This is where we would recommend you make a Sec. 83(b) election to recognize ordinary income when you receive the stock. This election, which has to be made within 30 days after receiving the stock, allows you to convert future appreciation from ordinary income to long-term capital gains income and defer it until the stock is sold.
The Sec. 83(b) election can be beneficial if the income at the grant date is negligible or the stock is likely to appreciate significantly. With ordinary-income rates now especially low under the Tax Cuts and Jobs Act (TCJA), it might be a good time to recognize such income.
Understanding the disadvantages
It is important though to recognize the potential drawbacks from taking the 83b election. Including:
- You must prepay tax in the current year — which also could push you into a higher income tax bracket or trigger or increase the additional 0.9% Medicare tax. If your company is in the earlier stages of development, the income recognized may be relatively small and may not make a large impact.
- Any taxes you pay because the election cannot be refunded even if you eventually forfeit the stock or sell it at a decreased value. However, you could have a capital loss in those situations.
- When you sell the shares, any gain will be included in net investment income and could trigger or increase your liability for the 3.8% net investment income tax.
Bottom line, it can be complicated
As you can see, tax planning for restricted stock is complex and varies on each taxpayer’s individual situation. Let us know if you’ve recently been awarded restricted stock or expect to be awarded such stock this year. We can help you determine whether the Sec. 83(b) election makes sense for your unique situation.