Definition
The term Section 83(b) elections refers to the Internal Revenue Code that allows individuals to immediately declare the excess of fair market value of property transferred to them as gross income in the current year. Section 83(b) elections are of particular importance to individuals receiving shares of restricted stock options.
Such an election can be made if the property transferred is not subject to substantial risk of forfeiture, and applies to the non-vested portion of such transfers.
Explanation
Stock grants and awards typically provide a select group of employees with an immediate share of company ownership through the transfer of common stock they can purchase at a discount or receive free of charge. Generally, these plans fall into two categories: unrestricted and restricted shares. Unlike restricted programs, unrestricted grants and awards will involve a vesting schedule, whereby the employee is entitled to retain ownership of the shares of stock over time or when certain performance standards are achieved.
When grants of stock are subject to restriction, the tax law allows the employee to declare the bargain element of the award as income as the shares become vested. In doing so, restricted grants of stock act like a deferred compensation plan, and allow the employee to spread the income tax burden over time.
A Section 83(b) election allows the employee to lock in this compensation when the employee's rights to the property are transferable, or when there is no longer a substantial risk of forfeiture, whichever is earlier.
While the vesting schedules associated with restricted shares appear to be advantageous to the employee, if the market price of the company's common stock rises rapidly, the bargain element may be considerably higher than when first granted. The tax law allows employees to lock in this compensation through the use of a Section 83(b) election.
An election under Section 83(b) is subject to several restrictions. For example, the transferred property must have an ascertainable fair market value. The required paperwork must also be filed with the IRS no later than 30 days after the transfer of the property to the employee. The company granting the stock should also receive a copy of the paperwork filed with the IRS, and the document should be attached to the current year's federal income tax return. An example document can be found here: Sample 83(b) Letter.
Making a Section 83(b) election will place a larger income tax burden on the employee in the near term. However, if the employee believes the market value of the transferred stock will rise substantially before the shares vest, the overall tax burden may be smaller.
Example
Company A has awarded its CEO 1,500 shares of restricted stock. As long as the CEO remains with the company, she will receive the 1,500 shares of Company A's common stock free of charge. While the current market price of Company A's common stock is $30.00 per share, the CEO believes the stock will be valued at $60.00 per share three years from now. The taxable portion of these restricted shares would be calculated as:
| End of Year 1 (500 shares at $40 per share) | $20,000 |
| End of Year 2 (500 shares at $50 per share) | $25,000 |
| End of Year 3 (500 shares at $60 per share) | $30,000 |
| Total Compensation | $75,000 |
In order to lower her overall tax burden, Company A's CEO has decided to file a Section 83(b) election. In doing so, her total taxable compensation would be:
= 1,500 shares x $30.00, or $45,000
By making this election, the CEO will have $75,000 - $45,000, or $30,000 less in taxable income if Company A's stock increases to $60.00 per share.
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