Restricted Stock and the Code Sec. 83(b) Election

The value of stock that your employer transfers to you as compensation for your services is includible in your gross income either in the first tax year in which you are not subject to a substantial risk of forfeiture, or when you can transfer the stock free of the substantial forfeiture risk, whichever occurs earlier.

By way of example, you will be entitled to 1,000 shares of stock if you complete two years of employment following the date on which this restricted stock is granted. Under the tax rules, you can either defer the income attributable to the grant of this restricted stock until your rights in the stock become vested, or elect, by making a Code Sec. 83(b) election, to recognize income at the time the stock is granted.

A Code Sec. 83(b) election must be made within 30 days of the grant of restricted stock. The amount of the income recognized as a result of the election is based on the fair market value (FMV) of the shares on the date of grant. The stock's FMV isn't reduced to reflect the restrictions on the stock, unless there is a permanent limitation on the transfer of the stock that would require you to resell the stock to your employer at a price determined under a formula.

The advantage of accelerating income through a Code Sec. 83(b) election is that you won't be taxed on any future appreciation in the stock until you sell the stock, at which time it will be taxed at capital-gain rates.

If you don't make the Code Sec. 83(b) election, you will be treated as receiving taxable income equal to the stock's FMV on the date the restrictions lapse.

Here's an example of how a making Code Sec. 83(b) election can be advantageous. Assume that: you are granted 1,000 shares of restricted stock in Year 1 when their value is $100 per share. The restrictions on the stock lapse in Year 2 when the stock is worth $160 per share. You sell the shares in Year 3 for $200 per share. In that case:

If you don't make a Code Sec. 83(b) election, you will be taxed on $160,000 of ordinary compensation income in Year 2 and $40,000 of capital gain in Year 3.

If you make the Code Sec. 83(b) election, you will be taxed on $100,000 of ordinary compensation income in Year 1, and on $100,000 of capital gain in Year 3.

The benefit of the Code Sec. 83(b) election to you, on the above assumed facts, is the postponement of tax on the $100,000 post-election increase in the value of the stock until Year 3, and the taxation of the entire $100,000 of appreciation at capital gain rates, rather than only $40,000 if no election were made.

Remember, however, that you will forfeit your rights to the stock if you fail to remain with your employer for two years after the grant. If that happens, you won't be entitled to a refund of the tax you paid upon making the Code Sec. 83(b) election. However, you will be able to treat the forfeiture as a sale of the stock at a loss.

Generally, the deferred compensation rules under Code Sec. 409A, which include certain deferred compensation in income to the extent not subject to a “substantial risk of forfeiture”, don't apply to property not includible in income in the year of receipt under Code Sec. 83 because the property is nontransferable and subject to a substantial risk of forfeiture, or to property includible in income solely because of a valid Code Sec. 83(b) election.