One of our clients was being granted restricted stock from his employer, something that he had never been offered before. He was very excited about the prospect of this executive compensation until he began to talk about the tax implications. “When I become fully vested in this restricted stock program, I will pay income tax on all of those shares,” he said. “I know it’s not a large number at the moment, but at the rate we are growing, that could be a huge tax bill by the end of the five-year vesting schedule.”
He was looking for some comfort in his pessimism. However, rather than give him that, we offered him a strategy that could lower his tax implications in the long run. That strategy was filing an 83(b) election.
While filing an 83(b) election absolutely made sense for this client, there are many factors to consider before employing this method. Weighing these factors is just one reason why it is helpful to work with an executive financial advisor who has experience with this strategy. Here’s a closer look at the 83(b) election, a tactic often overlooked by executives being granted restricted stock, as well as some guidelines for when implementing this strategy might make sense.
What Is an 83(b) Election?
An 83(b) election is an Internal Revenue Code provision that allows an employee to pay tax on restricted stock when it is granted, rather than waiting until it is fully vested.
Paying income tax on restricted stock up front, using the current fair market value to measure the amount of income tax owed, has the potential to save you money in the long run. If you do this, when you decide to sell the stock, you would pay capital gains tax on any gain you realize. Capital gains tax rates can go as high as 20%, while regular income tax rates can climb to 37%, so the difference is significant and worth noting.
If you choose not to file the 83(b) election, you pay no taxes up front. Instead, you pay income tax on the full amount of the restricted stock at the market value when it is fully vested, assuming that you met all vesting requirements and your employer is solvent.
The obvious benefit of the 83(b) election is largely dependant on the performance of the employer between the time that the restricted stock is granted and the time in which they are fully vested. If you were to forego the 83(b) election and choose to pay income tax on the restricted stock when it vested—and the company performs well and the valuation of the stock price is greater than when the stock was granted—you would pay income tax on the growth as well as the initial stock value.
Understanding an 83(b) election is the first step in deciding if this strategy is right for you. Let’s take it a step further and discuss when this method might make sense to pursue.
When Filing an 83(b) Election Makes Sense and Why
There aren’t many times in life when one would voluntarily pay income tax ahead of time. And that is, in fact, exactly what it means to file an 83(b) election. So that begs the question, when does it make sense to file an 83(b) election? The answer is, of course, “It depends.” It depends up your unique financial and professional situation. However, here are some general guidelines that point toward pursuing this type of strategy:
- You have faith that your employer will continue to grow, and you have hard numbers to support that belief. If you believe your company stock will continue to rise, paying income tax on a lower valuation of the stock will save you the added income tax owed if the stock is worth more at the time it is fully vested.
- You believe that you will continue to work for your employer at least through your vesting schedule (typically three to five years). Usually, if you leave the company before your restricted stock is fully vested, you forfeit them. The IRS does not allow a retraction of the 83(b) election. So, if you left the company prior to your restricted stock being fully vested, you would also forfeit the income tax you voluntary paid ahead of time.
- You plan to meet all requirements of your vesting schedule. Vesting schedule requirements can be tied to personal performance or time commitments. As stated in the point above, if you don’t plan to meet all requirements of your vesting schedule, you risk forfeiting your restricted stock. If this happened and you filed an 83(b) election, you would also lose all of the income tax you prepaid when the restricted stock were granted.
- You believe your company will stay financially solvent throughout your vesting schedule and beyond. This will give you peace of mind knowing that the restricted stock will be there for you when you fully vest. This is a good indicator that an 83(b) election could be a good fit for your situation.
While this is not an extensive list of requirements, it does give you a starting point to pursue the path of an 83(b) election. Of course, just like any other financial strategy, it is not a one-size-fits-all tactic. There are times when you might reconsider filing an 83(b) election.
If, for example, any of the above guidelines aren’t true of your situation—you aren’t confident your organization will continue to grow or remain solvent, or you don’t believe you can meet the requirements of your vesting schedule—you may be better off not filing an 83(b) election.
Also, you should know your organization receives an expense tax deduction benefit when you file an 83(b) election. Because of this, some companies will strongly suggest or even set 83(b) filing stipulations on contracts that offer restricted stock. This is something you need to be aware of before making a filing decision. Just because your company pushes this strategy doesn’t always mean it is in your best interest. This could especially be true if your company was recently purchased and you are new to restricted stock.
Enlisting an Expert for Your 83(b) Election
Filing an 83(b) election can be an advantageous strategy for many executives who are granted restricted stock. However, there are factors to consider before deciding that this is the right strategy for your financial plan. This is why it is important to work with an experienced executive financial advisor who has helped top-level employees navigate these same scenarios. The right advisor can walk you through the process of making this election. Doing this, you can feel confident knowing you’re implementing a strategy that makes the most sense for your unique financial situation.
K. Wade Carpenter, CFP®, AIF®, ChFC®, CLU®, is an innovative wealth manager serving corporate executives and entrepreneurs from coast to coast. Throughout his more than 25-year career, Wade’s focus on C-level clients has made him a top strategist for equity compensation planning. For more information on how Wade and the Carpenter Team can advise you on filing on an 83(b) election, reach out today for a complimentary consultation.
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