If you possess restricted stock you likely work either with a startup or some form of early stage company. Therefore, while there is certainly risk in holding restricted stock due to the uncertainty of an organization’s long-term viability, early stage stock may possess unique upside potential. To properly maximize and capture that upside potential while limiting downside risk is key to thoughtfully building and preserving wealth. Below we discuss in greater detail what exactly restricted stock is and a planning technique (an 83(b) election) that can often make sense.
What is Restricted Stock?
Restricted Stock is simply stock awarded by a company to employees, board members, directors or independent contractors. As referenced above, it is most often awarded within early stage companies, typically (though not exclusively) pre-IPO. The stock is restricted in the sense that before it can be enjoyed by the recipient the awarded stock is subject to vesting. Until the stock has vested, the stock is not fully owned - and thus why it is “restricted”. Restricted stock most often vests over a period of time; commonly over the course of three or four years from when it is originally granted or awarded. As an individual vests in restricted stock, ordinary income is recognized equal to the value of the stock at the date of vesting. The income is essentially compensation income as the government views the “free” value you’ve received in the form of stock to be the equivalent of having received income - just rather than cash the restricted stock holder received value in the form of stock. This income should appear on Form W-2 or 1099-MISC at the end of the tax year. If for any reason the stock recipient does not fulfill the vesting term (i.e. termination of employment) the stock is generally forfeited and returned to the issuing company.
Restricted Stock grants are most common with startup or early stage companies when spare cash flow to compensate top performers may be limited and stock being awarded has little to no value initially. It is a great way to incentivize an alignment of employee actions with longer-term company growth goals, all while reducing the current cash outflow required to retain key talent. In this situation a restricted stock recipient can make an 83(b) election on the property received - a unique tax election that can be very advantageous in the right situation as we shall detail below.
Restricted Stock is NOT a Restricted Stock Unit
We have written about Restricted Stock Units (RSUs) in the past. It is important to note that Restricted Stock and RSUs are NOT the same. While Restricted Stock is actual stock that has been awarded, RSUs are units that represent stock upon vesting. Further, restricted stock holders may accrue and receive dividend payments on the underlying company stock. RSUs are not actual stock until vesting and lack this component unless the company additionally awards dividend equivalent units (DEUs) for RSU holders. RSUs tend to be quite common with established public companies whereas restricted stock is most common with earlier stage ventures. There are other important distinctions between the two beyond the scope of this discussion.
Functionally, restricted stock and RSUs can appear very similar as both are subject to vesting schedules and upon meeting a vesting milestone, unrestricted shares of the actual company stock are received. The primary difference again is that restricted stock has been stock the entire time (just with a restriction of use placed on it since the holder does not own it free and clear until vesting), whereas RSUs are units that represent a future promise to receive stock at vesting - when units convert to stock. This functional difference however leads to a key difference in how to plan as we will see in the next section.
What is an 83(b) Election and why should I care?
Restricted stock has the advantage over RSUs in that the restricted stock holder can make what is referred to as an 83(b) election. This election, named after a section of the Internal Revenue Code, allows for an opportunity to accelerate the taxation that otherwise would have occurred at vesting. This can can potentially lead to favorable tax results and greater overall retained wealth. Why should you care? If properly implemented and planned for in the right situation it can save a restricted stock holder a tremendous amount of money in the long-term.
Here is how it works. An 83(b) election permits the holder of restricted stock to elect to be taxed on their property (stock in this case) once it has been awarded, rather than waiting until it fully vests. If an 83(b) election is made by the property (restricted stock) holder, they will recognize income in the amount of the fair market value of the shares at the time of election in excess of any cost basis (what was paid for - often times zero).
It is important to note that an 83(b) election must be made within 30 days of receiving the shares and is completed by providing notice to the IRS affirmatively stating that the shareholder is making such an election.
Why would you do this? Why would someone choose to accelerate the recognition of income you may ask? An example may help illustrate why this can be good planning under the right circumstances.
Joe Employee is a key early employee of a startup that has a positive outlook for future growth in several years as it becomes further cash-flow positive and matures. He receives 25,000 shares of restricted stock at no cost to him when the fair market value is $1 per share. The shares vest all at once at the end of four years.
If Joe were to properly make an 83(b) election on all 25,000 shares he would recognize $25,000 of taxable income in the year 1 when the restricted stock is awarded. Voluntarily recognizing $25,000 of ordinary income up front may not seem like a smart decision at first glance. Assuming Joe is in a 40% combined tax bracket, his liability on this election could be $10,000. If, however, in four years the stock price had risen to say $20/share, Joe will have wished he made the §83(b) election back in year 1 when he had the chance. If Joe had not made the §83(b) election, he would incur $500,000 of ordinary income in Year 4 and with the same tax rate being applied would have a tax liability of potentially $200,000. This is a $190,000 difference! Further, with such a large income event, Joe is likely to have an even higher tax rate than before and may owe even more than $200,000.
If in Year 6 the stock holder can sell for $25/share and decides to sell their entire position noted above, they would yield significant capital gains under both approaches though the 83(b) approach yields much higher gains. In the end however, as long-term capital gains are taxed at a lower rate than ordinary income, the overall tax cost is considerably lower by using the 83(b) approach.
What happens however if the stock price never rises or even falls? What happens if the restricted stock holder leaves before the vesting period concludes? It’s easy to look back and say of course an 83(b) election makes sense if you know what the price will be in the future, but of course this isn’t reality. If the stock price falls to less than $1/share after making the 83(b) election, upon receiving the actual shares the shareholder would have the ability to sell the shares for a capital loss. If the restricted stock holder had made the election but did not fully vest (left the company, did not meet other metrics required for vesting, etc.) no loss is permitted for tax purposes. The potential tax leverage involved here by making the election when the share price is quite low, can sometimes be worth the risk if proper planning has been performed.
Who should consider an 83(b) election?
This discussion neither addresses each and every last consideration of 83(b) elections and restricted stock nor does it consider the totality of each person’s unique financial situation. We strongly encourage that restricted stock (and any other equity award recipients) engage a qualified professional to help plan in this space. Many grant recipients may have several tranches of restricted stock that vest at varying times, or perhaps other types of competing equity compensation programs like ISOs, NSOs, RSUs, ESPPs, and more - all on top of everything else occurring in their financial world. However, below are some high-level indications of when an 83(b) election on your restricted stock may make sense.
You are a Key Employee - You are likely to stay with your company for the duration of the vesting period as required. If you will not be with the company for the required period to fully vest in your restricted stock, then an 83(b) election will not make sense.
You are an Early Employee - The earlier you are an employee, the more likely you may be to receive restricted stock at the lowest possible price. This is advantageous for purposes of 83(b) planning. If the price is only a few dollars a share or less, the downside risk may be minimal while the likelihood of locking in long-term gain is considerable.
You are willing to assume a small amount of accelerated risk for a potentially high reward - The appeal of the 83(b) election is often the long-term tax planning benefit. However, by willingly agreeing to accelerate your tax, there is risk in that if you do not see out the entire vesting period that pre-paid tax becomes a complete loss. However, the long-term potential reward may be significant. All else being equal, the lower the cost up-front the more likely an election could make sense.
You have ample liquidity - Making an 83(b) election can require a more than modest cash outlay to pay the required tax on the restricted stock. Before making the election, ensure that planning is in place to have the necessary funds available to pay associated taxes. Even if an 83(b) election is not made, there will be a need to possibly pay a large tax bill when the normal vesting would occur if the price rises. However, many employers will allow for a net number of shares to be withheld upon vesting to help pay the value of tax required. This is not necessarily available when making the 83(b) election.
You have a financial plan in place - To properly coordinate the tax, investment, and liquidity concerns a restricted stock recipient should strongly consider having a financial plan or ongoing guidance in place. How much company stock is too much? What is your investment timeline? What is your risk tolerance? What are your real goals? The answers to these questions and a real financial plan will help practice patience and a strategic approach to how restricted stock strategy fits into achieving larger financial goals.
At Hudson Oak Wealth Advisory, we have experience working with professionals at young companies that need guidance understanding the benefits and risks to having restricted stock - among other equity grant programs. If you feel that you could be getting more out of your workplace equity compensation program, we’d be happy to offer guidance. Please feel free to contact us or schedule an introductory call.
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