Taxation of Restricted Stock Compensation
Highly desirable employees are often compensated with either restricted company stock or options on the company stock, in addition to their wages and other benefits. The employee usually pays little or nothing for the restricted stock, but the stock does not vest until the employee satisfies certain requirements, the most common of which is to work for the employer for a minimum duration. Stock that is received as part of the compensation package for services provided, whether by an employee or an independent contractor, but is subject to restrictions, is taxed under different rules than other forms of compensation. Unless Section 83(b) applies, no tax is paid on the stock until it is vested, meaning that it is either transferable free of the restrictions or not subject to forfeiture, such as a risk that depends on future work performance. So that any transferees know about the restriction, restricted stock is commonly stamped as restricted. When the stock becomes vested, the difference between the amount paid for the stock and its value when the risk of forfeiture is eliminated, must be reported as wages, subject to both the federal marginal tax plus employment taxes. Any subsequent appreciation is taxed as capital gains that may also be subject to the 3.8% Medicare tax when the stock is sold. If the stock is held for at least 1 year after vestment, then the more favorable long-term capital gains rate applies.
Besides the restrictions of the employer, there may be other applicable restrictions because of security laws, such as SEC restrictions on insider trading, which will affect the stock valuation, so no tax is due on the receipt of such restricted stock. However, if the taxpayer received an option for stock and held the option for at least 6 months, then the SEC permits insiders to sell the stock after exercising the option. Hence, the taxpayer must pay tax in the year the option is exercised, even if the stock is not sold. A major advantage of restricted stock over compensating employees with stock options is that restricted stock can retain some value if the stock does not perform well while options may become worthless. The employer also has the option of giving more restricted stock to the employee if the stock did not appreciate as expected.
The taxpayer could choose a §83(b) election that allows the taxpayer to recognize as wage income the difference between the fair market value of the stock when it is received minus its cost. The election must be made by filing a statement with the IRS either before the stock is transferred or no later than 30 days after the transfer, and cannot be revoked unless the IRS consents. Although the additional wage income will have to be reported in the year that the election is made, the advantage of the election is that appreciation is not taxed on the stock when it becomes vested but only when it is sold, and then the income is treated as capital gains rather than as wages. If the stock is forfeited after the election, then a capital loss can be claimed equal to the amount realized from the forfeiture minus its cost. However, if the stock loses value before becoming vested, then the employee would have paid ordinary income tax that would not have been paid if not for the §83(b) election. Therefore, the §83(b) election should be made only if:
- the employee is fairly certain that the vestment requirements will be satisfied and
- the company stock is expected to appreciate substantially.
If the restricted stock was sold before vesting, and §83(b) was not chosen, and the restricted stock is sold to an unrelated party, then the gain must be reported as compensation in the year of the sale. If the buyer is a related person, then compensation must not only be reported in the year of the sale, but also when it becomes substantially vested, even though the taxpayer may no longer own the stock. The income would be equal to the fair market value of the stock when it becomes vested minus its cost and minus the compensation reported on the earlier sale.
Examples of Restricted Stock Taxation
Case #1: You buy 100 shares of your employer's stock for $10 a share when the fair market value of the stock was $50 a share. You must work for your employer for at least 5 years; otherwise, you will have to sell the stock back to your employer for the same amount of money. After 5 years, the stock becomes vested and your gain of $50 – $10 = $40 per share becomes taxable as wages.
Case #2: In the year that you received the stock, you file a §83(b) election with the IRS, so that you can report the income of $40 × 100 = $4000 as wages. When the stock becomes vested, no taxes are due. Your tax basis in the stock is now the $10 per share that you paid for it originally, plus the $40 per share that you reported as wages. So if you sell the stock for $120 a share, your gain of $120 – $10 – $40 = $70 per share is treated as a long-term capital gain.