What You Should Know About an 83(b) Election and Restricted Stock

A restricted stock plan is a compensation tool offered by employers to attract and retain key employees. Often times the restricted stock is not owed by the recipient until certain conditions are met, which is often the passage of a specific period of time.

During this restricted period, the employee maintains no ownership rights to the stock. The stock is not the property of the employee during the restricted period, and so the value of the restricted stock is not taxable income.

When the restriction lapses (or the time period is met), the restricted stock vests and immediately becomes the property of the employee. It’s at this time that the value of the shares is taxable, just like normal employee income.

The process of paying taxes on vested restricted stock can be accomplished through both cash and cashless transactions.

For many reasons, waiting until a restricted stock vests to pay taxes can be an attractive strategy. Simply put, it is the path of least resistance. Furthermore, waiting for a stock to vest provides certainty to the value of the shares received. Subsequently, the recipient of the restricted stock pays income tax on the value that was actually received.

However, this path of least resistance is not the only option for recipients of restricted stock. For employees with a substantial amount of restricted stock, restricted stock at a low grant price, restricted stock of a company you expect to substantially appreciate, and/or restricted stock granted during a year with a low income, it may be wise to consider an alternative tax reporting option known as an 83(b) election.

What Is an 83(b) Election?

If you find yourself on the receiving end of restricted stock, it may be important to consider the benefits and drawbacks of an 83(b) election.

As discussed above, restricted stock is typically taxed when it vests. One such example of vesting restricted stock can be three years following the grant date.

An 83(b) election allows an employee to pay ordinary income tax on restricted stock in the year in which it is granted (as compared to the year it vests). By making this election, the employee is taxed on the value of the restricted shares when they were granted. Any further increase in stock price may be subject to potentially preferential capital gains treatment.

The shares will still have a vesting schedule, during which the employee does not own the shares and maintains the risk of forfeiture.

It is during this period that the employee of the restricted shares is at risk. The specific risks include the following:

  • Paying tax on stock that they may never receive (This could be the outcome should the employee not meet the specific conditions, so the shares never become property of the employee.)
  • Paying tax on the value of the stock upon grant and subsequently having the price fall below the grant price, resulting in the employee paying more in taxes than what they would have paid had they not exercised the 83(b) election

For assuming risk, the employee is seeking to exploit a tax planning opportunity. By choosing an 83(b) election, the employee is seeking to receive preferential capital gains tax rates on future price appreciation. Furthermore, they may be seeking control of when to sell the shares and incur the tax liability.

Using a hypothetical example, we can explore the math comparing an 83(b) election versus no 83(b) election. For our purposes, we will assume a 33% ordinary income tax rate and a 15% long-term capital gains tax rate.

  • Number of shares – 1,000
  • Grant Price – $10.00
  • Vesting Price – $25.00

When comparing the two in a simplified example, we see the following:

No 83(b) Election 83(b) Election
Value at Grant $10,000 $10,000
Tax at Grant (33%) $0.00 ($3,300)
Value at Vesting $25,000 $25,000
Taxable Amount at Vesting $25,000 $15,000
Tax at Vesting ($8,250) ($2,250)
After-Tax Proceeds $16,750 $19,450

 

In this simple illustration, one could argue that for an appreciating stock, the 83(b) opportunity is an attractive one. In our example, the proceeds of the 83(b) election result in an after-tax result value that is over 15% higher than not choosing the 83(b) election.

(In this example, we do not consider the opportunity cost of the $3,300 of pre-paid tax using the 83(b) election. See below for more on this.)

A Look at the Risk of an 83(b)

It is important to consider what is at risk when electing an 83(b). In the example above, one could define the amount of risk as the cost to perform the 83(b) election, with that cost being the taxes paid upon the shares being granted, which is $3,300.

In this example, the cost (and therefore the amount at risk) is low. For that reason, many might find this to be an attractive opportunity.

However, as the out-of-pocket costs to perform an 83(b) election become more substantial, it may prove more difficult for an employee to make the 83(b) election. For example, what happens when the value of the restricted grant increases from $10,000 to $100,000 and the value at vesting increases from $25,000 to $250,000?

No 83(b) Election 83(b) Election
Value at Grant $100,000 $100,000
Tax at Grant $0 ($33,000)
Value at Vesting $250,000 $250,000
Taxable Amount at Vesting $250,000 $150,000
Tax at Vesting ($82,250) ($22,500)
After-Tax Proceeds $167,500 $194,500

 

From a mathematical standpoint, nothing has changed. The after-tax proceeds of the 83(b) election are over 15% higher than a no 83(b) election. All that has changed is the amount of risk for the employee.

In this example, electing an 83(b) will require an out-of-pocket tax cost of $33,000. Said another way, this employee electing an 83(b) has to pay $33,000 in tax in hopes that 1) they eventually receive the company stock as property and 2) the stock price appreciates above the grant price.

For most people, making a $33,000 bet is different from making a $3,300 bet.

A Breakeven Analysis for an 83(b) Election

The illustrations above paint a simple picture of an 83(b) election. In short, it illustrates an example in which an 83(b) may work out in an employee’s favor. It also illustrates the risk of loss assumed by an employee who elects an 83(b) (and how the magnitude of this risk may impact your decision making).

This simple illustration further begs the question: What is the breakeven analysis on an 83(b) election? What rate of return do I need to achieve to make the 83(b) worthwhile?

To find the answer, we must again create a hypothetical example from which we can illustrate the math. To do so, we have assumed the following:

  • Time Period – 3 years
  • Tax Rates
    • Ordinary Income – 33%
    • Long-Term Capital Gains – 15%
  • Initial Value – $10,000
  • Opportunity Cost – 7%

Using these assumptions, we can model what rate of return is required to equalize the after-tax proceeds of an 83(b) election with the after-tax proceeds of not electing an 83(b).

No 83(b) Election 83(b) Election
Initial Value $10,000 $10,000
Tax at Grant $0 ($3,300)
Opportunity Cost $743 $0
Required Rate of Return (12.21%) 4,128 4,128
Value at Vesting $14,128 $14,128
Tax at Vesting ($4,662)
Tax at Sell ($619)
After-Tax Proceeds $10,209 $10,209

 

In this example, a rate of return of 12.21% is required for the employee electing an 83(b) to equal that of no 83(b) election. Therefore, one could presume that if the stock price appreciates more than 12.21%, it is in the best interest of the employee to elect an 83(b).

Additional Breakeven Thoughts

It’s only fair in our analysis to evaluate a stock return of 12.21% versus the opportunity cost of investing in the market. For our analysis, we assumed the market rate of return is 7% per year. Therefore, the employer stock needs to provide excess returns greater than 5.21% to make the 83(b) election valuable.

If we continue our thinking, the example above is a representation of the breakeven analysis. What makes the two mathematically equivalent? Further analysis would also consider the risk assumed by the employee electing an 83(b). Going back to our example, the risk is losing $3,300 of pre-paid tax.

Assuming this risk, it is fair to figure that the employee is not interested in simply a breakeven. It’s reasonable to suggest that the employee is looking for an excess return to compensate them for their assumed risk of loss.

This begs the question: How much excess return (in excess of the 5.21% over the market) should the employee require in order to take on the risk?

This is not an easy question to answer.

A Second Option – No 83(b) but Buy Additional Shares

In the example above, the analysis assumes that the cost of performing the 83(b) election is $3,300. It further assumes these dollars are placed into an investment account and earn 7%.

However, investing into a brokerage account is not the only option. In fact, it’s possible these same dollars can be used to buy additional shares of company stock on the open market.

If we assume the above is true and we assume a 12.21% stock price rate of return, we can illustrate another scenario that should be considered.

No 83(b) Election 83(b) Election No 83(b) – Buy Shares
Initial Value $10,000 $10,000 $10,000
Tax at Grant $0 ($3,300) $0
Opportunity Cost $743 $0 $1,362
Required Rate of Return (12.21%) $4,128 $4,128 $4,128
Tax at Vesting ($4,662) ($4,662)
Tax at Sell ($619)
Tax Cost of Additional Shares (LT) ($204)
After-Tax Proceeds $10,209 $10,209 $10,624

 

In this analysis, the best outcome is the one in which you choose NOT to do an 83(b) election. Instead, take the dollars associated with the cost of performing an 83(b) election and buy additional company shares outright. (However, this would increase concentration risk compared to the market alternative.)

83(b) with Highly Appreciating Stock

A common reason for electing an 83(b) is the belief that the stock will greatly appreciate. In fact, combining what is believed to be a highly appreciating stock with a low grant price may be the holy grail of 83(b) elections.

To illustrate, let’s explore an example in which the grant price is $10,000 and the future sales price is $1,000,000 (three years later).

No 83(b) Election 83(b) Election
Initial Value $10,000 $10,000
Tax at Grant $0 ($3,300)
Opportunity Cost $743 $0
Value at Vesting $1,000,000 $1,000,000
Tax at Vesting ($330,000) ($148,500)
After-Tax Proceeds $670,743 $848,200

 

In this scenario, the after-tax proceeds of a stock that is highly appreciating are significantly higher than not electing an 83(b). This makes an 83(b) election seem like a no-brainer. However, it’s rare for such an appreciation to happen in such a short amount of time.

More likely, the high appreciation of a stock will occur over a longer time period. So what happens if this same appreciation occurs over 10 years?

If we assume the 10-year timeframe and assume linear growth of the stock, it’s fair to recognize that much of the growth in both scenarios will be at the preferential long-term capital gains treatment. This is due to the fact that shares vest after three years. This assumption makes the 83(b) election significantly less attractive.

No 83(b) Election 83(b) Election
Initial Value $10,000 $10,000
Tax at Grant $0 ($3,300)
Opportunity Cost $3,192 $0
Value at Vesting $39,811
Tax at Vesting ($13,138) $0
10-Year Rate of Return (58.49%) $1,000,042 $1,000,042
Opportunity Cost $7,959
LT Capital Gains Tax ($144,035)
Tax at Vesting ($148,506)
After-Tax Proceeds $846,061 $856,195

 

Many of the dollars in both of these scenarios are subject to the same long-term capital gains rates. The result? The value of the 83(b) election is minimized.

From these two examples, we can conclude that an 83(b) election is most advantageous when the stock appreciates during the period in which the substantial risk of forfeiture exists.

Closing Thoughts on an 83(b) Election

On the surface, the opportunity to pay long-term capital gains tax instead of ordinary income tax is attractive. For this reason, an 83(b) election may be attractive. However, as we go through the analysis, the math in the hypothetical examples may minimize the opportunity.

More closely, it appears that an 83(b) election may create the most opportunity when the grant price of the restricted stock is low, the amount of risk is minimized, and the stock price is highly appreciating (something no one will ever know in advance).

All this leads to the fact that it’s important to evaluate what your stock award looks like and what opportunities exist. Knowing the right questions to ask and doing the right financial planning are key to being confident that you’re taking advantage of all the opportunities available to you.

Tax services are not offered through, or supervised by Lincoln Investment, or Capital Analysts.

None of the information in this document should be considered as tax advice.  You should consult your tax advisor for information concerning your individual situation.

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