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Sept. 17, 2019, 10:20 a.m. EDT

This is when you should decide to get taxed on restricted stock awards

Some companies are offering restricted tax awards instead of or in addition to more-traditional stock option awards

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By Bill Bischoff


Getty Images/iStockphoto
Deciding on when to get taxed on restricted stock depends in part on how long you think federal tax rates will stay relatively low.

Restricted stock awards have become a popular way for companies to offer equity-oriented executive compensation.

Some companies are offering them instead of or in addition to more-traditional stock option awards. The reason: options can lose most or all of their value if the price of the underlying stock takes a dive. But restricted stock retains significant value even after a price decline, as long as the stock retains significant value. And if the stock price does down, your company can easily issue you some additional restricted shares to make up the difference.

So far, so good. But what about taxes, you ask? Please keep reading for questions and answers.

How does a restricted stock award work?

In a typical restricted stock deal, you receive company stock subject to one or more restrictions. The most common restriction is a requirement that you must continue working for the company until some magic date. If you leave too soon, you forfeit the restricted shares, which are usually issued at minimal or no cost to you.

What is the tax-law definition of restricted stock?

For federal income and employment tax purposes, stock is considered to be restricted (meaning not vested) when both of the following conditions are met.

Substantial risk of forfeiture: This condition is met if ownership of the stock depends on the future performance of substantial services by you.

Not transferable: This condition is met if upon any transfer of the restricted shares by you to another party, the new holder’s rights to the stock are still subject to the same substantial risk of forfeiture. For instance, stock meets the not-transferable requirement if you can sell the shares but the new holder must forfeit them to your employer if you fail to deliver the required services by leaving the company too soon.

Key point: To be clear, restricted shares are transferred to you, but you don’t actually own them without any restrictions until they become vested. To ensure that the non-transferable requirement is met, restricted shares are commonly stamped with a legend that discloses the restriction(s) placed on them and/or indicating that they are not transferable.

How is a restricted stock award taxed?

The general rule says you don’t have any taxable income from a restricted share award until the shares become vested, meaning when your ownership is no longer restricted. At that time, you are deemed to receive taxable compensation equal to the difference between the value of the shares on the vesting date and the amount you paid for them, if anything. The income, which includes any post-award appreciation in the value of the shares, will be hit with federal income and employment taxes and state income tax if applicable.

In other words, any share-price appreciation that occurs between when the restricted shares are awarded to you and when they become vested will be taxed at your regular federal rate, which under the current rules could be as high as 37% plus 3.8% for the Medicare employment tax on compensation income plus state income tax, if applicable.

Any appreciation after the shares vest is treated as capital gain. So if you hold the stock for more than one year after the vesting date, you will have a lower-taxed long-term capital gain on any post-vesting-date appreciation. The current maximum federal rate on long-term capital gains is “only” 20%, but you may also owe the 3.8% net investment income tax (NIIT). So, the combined rate could be as high as 23.8% plus state income tax, if applicable.

Should I make the special tax election to get taxed right now on my restricted shares?

Maybe. If you choose to make the special Section 83(b) election you recognize taxable income at the time you receive your restricted stock award instead of later when the restricted shares actually vest. In other words, making the election triggers taxable income before you fully own the shares. That income is treated as additional compensation that is subject to federal income and employment taxes and state income tax, if applicable.

The income amount equals the difference between the value of the shares at the time of the restricted stock award and the amount you pay for them, if anything.

The benefit of making the election is that any subsequent appreciation in the value of the stock is treated as capital gain. So, if you hold the stock for more than one year, you will have a lower-taxed long-term capital gain.

What is the downside of making the special election?

You must recognize taxable income in the year you receive the restricted stock award, even though the restricted stock may later be forfeited or decline in value. If you have to forfeit the shares back to your employer, you can claim a capital loss for the amount you paid for the shares, if anything. However, you get no break for the taxable income that you reported and paid tax due to making the 83(b) election.

OK, should I do it or not?

That’s for you to decide, but let me give you some wisdom. The Section 83(b) election only makes sense when: (1) you expect to stay on board with your company until the restricted shares vest and (2) you expect substantial share-price appreciation.

But right now, there’s another reason to consider the election. If you make it while today’s historically low federal income tax rates are in force, the tax hit will be “reasonable.” But how long will the current low rates last? Who knows? It depends on the outcome of the 2020 general election. If the Democrats seize control, you can pretty much count on higher tax rates, especially for upper-income folks who are the most likely candidates to receive restricted stock awards. Higher rates would reduce the attraction of making the election. So, if you’re going to do it, now is probably the best time.

If you decide to make the election, you must notify the IRS either before the restricted stock is transferred to you or within 30 days after that date. Your tax pro can help you with the election details.

The bottom line

The tax rules for restricted stock are fairly straightforward. The major tax planning consideration is deciding whether or not to make the Section 83(b) election. You might tentatively conclude that the risks of making the election are greater than the potential tax-savings, but consider consulting with your tax pro before making the call.

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