Should Employees Joining a Start-up Make a “Section 83(b) Election” on Restricted Stock Awards?
A “Section 83(b) election” refers to a tax election available under Section 83(b) of the Internal Revenue Code (the “Code”). Generally, employees receiving restricted stock as compensation for services to a company must report income (and pay tax at ordinary income tax rates) when the stock is no longer subject to a substantial risk of forfeiture (i.e., the stock vests). The amount included in income is the difference between the fair market value of the stock upon vesting and the purchase price paid, if any, for the stock. Often restricted stock is granted with no purchase price so the amount taxable to the recipient is the full fair market value at ordinary income tax rates. Once vesting occurs and tax is paid at ordinary rates, if the stock is held and continues to go up in value before it is sold by the recipient, the additional increase in value is taxed at the applicable capital gains rate provided the one-year holding period is met.
However, Section 83(b) of the Code allows employees receiving restricted stock to make an election to recognize income on the restricted stock in the year the restricted stock is awarded rather than wait until the year of vesting when the fair market value of the stock is expected to be greater. In the year of the award, the value of the stock is often nominal and including that nominal value in income when the restricted stock is awarded is often a significant tax savings for the recipient as compared to the tax that would be due on the stock in the year of vesting without the election.
One drawback to making a Section 83(b) election is that since the stock is not vested when the election is made, the stock may be forfeited. The consequence of forfeiting restricted stock with respect to which a Section 83(b) election was made is simply that the recipient paid tax on unrealized income and the tax paid cannot be recouped through a subsequent deduction. Despite this drawback, in instances where the income to be reported if the election is made is small, most recipients of restricted stock make the election.
To make a Section 83(b) election, the election must be filed with the Internal Revenue Service within 30 days of the date the restricted stock is awarded. If this time period is missed, the opportunity to make a Section 83(b) election is lost.