Taxes on Restricted Stock for Employees
Beverage manufacturers, distributors, and vendors–like other closely held companies–often use grants of their own stock to compensate and incentivize employees, consultants and other providers (for simplicity, this articles refers to all of them as “employees”). These grants have major tax consequences.
News Flash: Stock Grants are Subject to Income Taxes
Generally, when money or property is given to an employee, consultant, or other person or firm in connection with services provided to the company, the value of that money or property is treated as taxable compensation. This has profound implications for both the employee and the company. For the employee, the compensation is subject to federal and state income taxes and the employee’s share of employment taxes. For the company, the payment of compensation to employees requires income tax withholdings to be withheld, and the company is also responsible to pay the employer’s share of employment taxes. This may be easily understandable when the employee is paid money, but it gets much more complicated when the employee is paid with the company’s stock, which may be subject to restrictions.
While this article speaks in terms of corporations granting restricted stock to employees, it is important to recognize that the same analysis applies to LLCs that have elected to be treated as a corporation for federal income tax purpose. Even though an LLC might issue membership units instead of stock, electing S corporation treatment causes the LLC and its employees to be subject to the same rules concerning restricted units and unit options.
5 Factors Matter for the Taxation of Restricted Stock
When employees, consultants, and others are granted stock in the company, the tax consequences depending on the following factors:
- Whether the stock is subject to a risk of forfeiture
- The vesting period
- The value of the stock at vesting (or earlier in the case of a Section 83(b) election)
- How long the stock is held by the employee prior to sale
- The price at which the employee sells the stock
Restricted Stock is not Earned Until it Vests
For income tax purposes, compensation paid with stock is earned by the employee when it is no longer subject to forfeiture. That is, while there are restrictions tied to the stock which mean that the employee could lose the stock (because of termination of employment, for instance), the restricted stock is not immediately treated as taxable income to the employee. It is not until the stock vests–when the company cannot freely take back the stock–that the stock is earned for income tax purposes.
Generally, it is the value of the stock when it is earned–when it vests–that determines the taxable income to the employee. If restricted stock does not vest for 5 years after the grant date (assuming the employee is still employed), then it is the value of the stock at the time of vesting–not at the time it was granted–that must be reported for income taxes and employment taxes. If the value of the company’s stock has grown over that 5-year period, the employee’s taxable income is greater at the vesting date than it would have been at the grant date.
Section 83(b) Elections: Opting Out of the Earned-When-Vested Rule
There are two ways companies and employees can get the benefit of the lower value at stock on the grant date. First, the company can issue stock to an employee without restrictions. However, companies are often unwilling to issue unrestricted stock to new employees, because they want to reward the employee for staying with the company over the vesting period. Second, the employee can make a special election to have the restricted stock treated as taxable income at the time it is granted.
By making a Section 83(b) election, an employee can report to the IRS that they have received compensation in the form of restricted stock and the employee wants to include the value of that stock in his or her taxable income immediately. The Section 83(b) election is a decision to ignore the “risk of forfeiture” requirement. It’s possible that this is a bad idea for the employee–for instance if the value of the stock is higher at grant date than it will be at the vesting date. But most companies and employees are optimistic about the growth of their stock value over a period of time. In that case, the 83(b) election results in the employee’s recognizing less taxable income immediately.
The Section 83(b) election is especially beneficial when the company is brand new. Before the company starts its operations–and for a undefined period of time after–the value of the company’s stock is zero. An employee who has been given restricted stock at a company’s inception can therefore choose–by making a Section 83(b) election–to immediately recognize income in the amount of the stock’s value at that time, zero.
The Section 83(b) election must be made within 30 days after the grant date. The election is made by sending a letter to the IRS (certified mail is recommended), at the address where the employee’s income tax return is required to be mailed. The election letter must identify the employee (by name and Social Security Number), the company (by name), the number of restricted shares granted to the employee, and the grant date. The election letter must also briefly describe the restrictions on the shares, especially the risk of forfeiture.
The Section 83(b) Problem for Non-Startup Companies
What happens when a company that has been in business for a period of time–say, a year or longer–wants to give restricted stock to an employee? It is still possible for the employee to make a Section 83(b) election, and recognizing taxable income at the grant date may still be better than waiting to recognize the income at the vesting date. However, it may no longer be plausible to claim that the value of the company’s stock on the grant date is zero. These means that, even when the Section 83(b) election is made, the grant of the restricted tax is still taxable.
The employee has the burden of establishing the value of the stock on the grant date, which is very difficult for a closely held company whose stock is not regularly traded. The IRS provides a safe harbor: it will accept the appraised value of the stock determined by a certified appraiser not more than 12 months prior the grant date. This appraisal is called a 409A valuation. Companies that routinely offer restricted stock or options to employees and others are advised to get a 409A valuation every year.
There’s More: Capital Gains Taxation Upon Sale
Whether the holder of restricted stock makes a Section 83(b) election or not, there are more tax consequences associated with his or her stock. A sale or exchange of the stock–whether or not it is still subject to restrictions–will incur capital gains taxation. Capital gain taxes are calculated on the basis of the difference between the holder’s sale price for the stock and the holder’s basis in the stock. A holder’s basis in the stock is the value of the stock for the recognition of taxable compensation income. That is, if the holder made a Section 83(b) election, the basis is the value of the stock on the grant date. Without a Section 83(b) election, the basis is the value of the stock on the date the stock vested (the risk of substantial forfeiture ended), which might also be the date on which the stock is sold.
In determining the capital gains from sale of stock, it matters how longer the stock was held after it was recognized as taxable compensation income. If the stock was held for more than 1 year after recognition (called long-term capital gains), then the capital gains tax rate is equal to 0%, 15%, of 20% (as of 2021) depending on income thresholds. If the stock was held for 1 year or less (short-term capital gains), then the capital gains tax rate is the same as the ordinary income tax rate.
Do you have any questions about giving restricted stock to employees, contractors and others? Contact us at email@example.com to schedule a consultation with a business attorney.
Because we’re attorneys: Disclaimer.