The Section 83(B) Election for Restricted Stock: A Joint Tax Perspective

Abstract

In the wake of the Financial Accounting Standard Board's decision to require firms that grant employee stock options (ESOs) to treat such options as an expense, many large and sophisticated firms are switching from ESOs to restricted stock. Restricted stock - stock granted to an employee as part of her compensation and subject to the condition that if she leaves the firm within a period of time (often 3 years) she forfeits the stock - appears to be on its way to becoming the dominant form of equity-based pay in the United States. Yet, in spite of its prominence, little attention has been paid to how employers should design their restricted stock programs in light of tax considerations. The tax consequences to both the employee and the employer of a grant of restricted stock are deferred until the restriction lapses and the stock vests. There is however an exception to that general rule: If, within 30 days of receiving the stock, the employee makes what is called the Section 83(b) election, then both the employer and the employee are taxed at the time of grant.

Employing a joint tax perspective that looks at the tax consequences to both the employer and the employee, this paper attempts to answer several compensation design issues raised by the use of restricted stock. Specifically, I address the question under what circumstances should the employer charge the employee explicitly for her restricted shares and when should the employer charge implicitly for the restricted stock through a lower salary. I also look at the desirability to the employee, the employer, and the employee and employer together of the employee making the Section 83(b) election. Finally, I look at the value to the employee and cost to the employer of the employee's option to wait 30 days until making the Section 83(b) election.

Keywords: Restricted stock, Section 83(b) election, taxation, executive compensation, equity-based pay, employee stock options, tax planning, compensation planning

JEL Classification: G30, H20, J33, K34