The taxation of restricted stock awards granted to founders, employees and other service providers can be confusing. The taxable event may occur at any or all of the following times: grant, vesting, or the sale of the shares. Basically, the founder, employees or other service provider may pay income tax on the value of the restricted stock award throughout the life of the stock award. Fortunately, under IRC section 83, the taxation of the restricted stock award can be made manageable and, at the same time, more cost efficient.
When a founder or service provider receives a restricted stock award, all or a portion of the shares issued are typically subject to a vesting schedule. The vesting schedule may extend over a number of years from the date of grant. The company retains a repurchase right over the unvested shares so that the unvested shares are transferred back to the company if the service provider does not satisfy the vesting requirements.
Under the U.S. tax rules, the excess of the fair market value of the shares on the vesting date or dates (the date or dates upon which the repurchase right lapses) over the amount actually paid for the shares by the service provider, if any, is taxed as ordinary income to the service provider in the tax year in which vesting occurs. For example, if the fair market value of the stock on the date of grant is $1, which was paid by the service provider, and the fair market value of the stock is $2 on a vesting date, the founder or service provider will pay income tax on the $1 increase in stock value in the year in which the vesting date occurs.
To avoid the taxation on the increased value of the shares on each of the future vesting dates as ordinary income, and to defer the payment of tax on the increased value of the shares until the shares are sold, the service provider may file a section 83(b) election with the IRS. In effect, the section 83(b) election accelerates the taxation of the restricted stock so that all income taxes due, if any, over the vesting period are payable at the time the election is made, but sets the taxable amount based upon the fair market value of the shares on the grant date. If the fair market value of the shares is equal to the purchase price actually paid by the service provider, a section 83(b) election will not result in any immediate recognition of ordinary income for the service provider (thus no tax due). However, if the fair market value of the shares is greater than the amount paid by the service provider (e.g., the service provider did not pay anything for the stock), a section 83(b) election will result in the difference between the fair market value of the shares and the amount paid being taxable as ordinary income to the service provider at the time of grant. In both cases, no additional income taxes will be due, and the founder or service provider only will pay capital gains tax when the shares are sold.
The section 83(b) election must be filed within 30 days of the date the shares are issued to the service provider. There is no option to extend the filing deadline. Once the deadline passes, a section 83(b) election filed by the service provider will not be accepted by the IRS.