About Restricted Stock Awards

A Restricted Stock Award Share is a grant of company stock in which the recipient’s rights in the stock are restricted until the shares vest (or lapse in restrictions). The restricted period is called a vesting period. Once the vesting requirements are met, an employee owns the shares outright and may treat them as she would any other share of stock in her account.

How do Restricted Stock Award Plans work?

Once an employee is granted a Restricted Stock Award, the employee must decide whether to accept or decline the grant. If the employee accepts the grant, he may be required to pay the employer a purchase price for the grant.

After accepting a grant and providing payment (if applicable) the employee must wait until the grant vests. Vesting periods for Restricted Stock Awards may be time-based (a stated period from the grant date), or performance-based (often tied to achievement of corporate goals.)

When a Restricted Stock Award vests, the employee receives the shares of company stock or the cash equivalent (depending on the company’s plan rules) without restriction.

Income Tax Treatment

Under normal federal income tax rules, an employee receiving a Restricted Stock Award is not taxed at the time of the grant (assuming no election under Section 83(b) has been made, as discussed below). Instead, the employee is taxed at vesting, when the restrictions lapse. The amount of income subject to tax is the difference between the fair market value of the grant at the time of vesting minus the amount paid for the grant, if any.

For grants that pay in actual shares, the employee’s tax holding period begins at the time of vesting, and the employee’s tax basis is equal to the amount paid for the stock plus the amount included as ordinary compensation income. Upon a later sale of the shares, assuming the employee holds the shares as a capital asset, the employee would recognize capital gain income or loss; whether such capital gain would be a short- or long-term gain would depend on the time between the beginning of the holding period at vesting and the date of the subsequent sale. Consult your tax adviser regarding the income tax consequences to you.

Special Tax 83(b) Election

Under Section 83(b) of the Internal Revenue Code, employees can change the tax treatment of their Restricted Stock Awards. Employees choosing to make the Special Tax 83(b) election are electing to include the fair market value of the stock at the time of the grant minus the amount paid for the shares (if any) as part of their income (without regard to the restrictions). They will be subject to required tax withholding at the time the restricted stock award shares are received. In addition to the immediate income inclusion, a Special Tax 83(b) election will cause the stock’s holding period to begin immediately after the award is granted.

With a Special Tax 83(b) election, employees are not subject to income tax when the shares vest (regardless of the fair market value at the time of vesting), and they are not subject to further tax until the shares are sold. Subsequent gains or losses of the stock would be capital gains or losses (assuming the stock is held as a capital asset). However, if an employee were to leave the company prior to vesting, he would not be entitled to any refund of taxes previously paid or a tax loss with respect to the stock forfeited.

A Special Tax 83(b) election must by filed in writing with the Internal Revenue Service (IRS) no later than 30 days after the date of the grant. Additionally, the employee must send a copy of the Special Tax 83(b) election form to their employer, and include a copy when filing their yearly income tax return.

Deciding Whether to Make a Special Tax 83(b) Election

Whether to make a Special Tax 83(b) election is an important tax and financial decision, and employees are urged to consult their tax advisers.

There are several potential advantages of making a Special Tax 83(b) election:

Establish cost basis now. By paying tax on the grant now, rather than when the shares vest, the current stock price will be established as the cost basis for the shares granted. When the shares do vest, no tax will be due until the shares are sold, regardless of how much the shares may have changed in value.

Control the timing of future income recognition. Gain (or loss) would be recognized only when the stock is actually sold and would not be triggered by the lapse of restrictions at vesting.

Capital gains treatment. Assuming the stock is held as a capital asset, future gains (or losses) would be taxed only as capital gains, and, therefore, would be subject to favorable capital gains tax rates.

There are also several potential disadvantages of making a Special Tax 83(b) election:

Falling share prices. If the stock price declined during the vesting period, there is a risk that more taxes would be paid based on the fair market value on the grant date than would have been paid at vesting.

Timing of tax payment. Since taxes are due when the award is granted, you will need to use other funds to pay the tax withholding obligation. Under normal tax treatment, you do not owe taxes until the grant vests and you could potentially use some of the shares vesting to cover your tax withholding obligation.

Risk of forfeiture. If the restricted stock award is forfeited (e.g., by leaving the company before the stock vests), a loss cannot be claimed for tax purposes with respect to the restricted stock award. Additionally, there is no refund on the tax paid on the restricted stock award.

Paying Income Tax on Restricted Stock Awards

Depending on plan rules, individuals who decide not to make a Special Tax 83(b) election have two options to meet their tax withholding obligation due at vesting – net shares or pay cash.

Individuals who elect to net shares will have the appropriate number of shares withheld at vesting in order to cover their tax withholding obligation. They will receive the number of shares vested less the number of shares withheld for tax purposes.

Individuals who elect to pay cash in order to satisfy their tax withholding obligation must have the appropriate amount of cash in their account on the day of vesting. The money will be debited from their account upon vesting and it will be forwarded to their company for reporting and remitting to the appropriate regulatory agencies. They receive the full number of shares that vested.

Federal Income Tax Treatment Regular Tax Treatment No 83(b) election Special Tax 83(b) election
Grant Date No current taxation – tax deferred until shares vest. Taxpayer taxed as ordinary compensation income at grant date on spread at grant date (difference between fair market value at grant date minus amount paid for stock, if any). Tax withholding and inclusion in income tax return for year of grant required.
Forfeiture No tax consequence. No risk of paying tax and forfeiting shares without tax benefit. Taxpayer is not permitted to claim a tax loss on the forfeiture; no recovery of taxes paid at grant date on Special Tax 83(b) election.
Vesting Taxpayer taxed as ordinary compensation income at vesting date on spread at vesting date (difference between fair market value at vesting date minus amount paid for the stock, if any). Tax withholding and inclusion in income tax return for year of vesting required. No tax consequence. Vesting does not trigger inclusion in income of any appreciation in value of shares; no further tax until sale or other disposition.
Holding period Holding period begins at vesting date, when the compensation element of restricted stock is included in income. Holding period begins at grant date, when the compensation element of restricted stock is included in income.
Subsequent sale of shares (assuming shares held as capital asset) Taxpayer is taxed on capital gain on difference between sale price minus taxpayer’s basis (the amount included in income at vesting plus the amount paid for the shares, which should be equal to the fair market value of the stock at vesting). Whether such capital gain would be short- or long-term gain would depend on the time between the beginning of the holding period at vesting and the date of the subsequent sale. Taxpayer is taxed on capital gain on difference between sale price minus taxpayer’s basis (the amount included in income at grant date plus the amount paid for the shares, which should be equal to the fair market value of the stock at the grant date). Whether such capital gain would be short- or long-term gain would depend on the time between the beginning of the holding period at grant date and the date of the subsequent sale.