Part 2: The Difference Between Stock Options and Restricted Stock

In part 1 of our two part series we explored, at a high level, the differences between the stock option plans, incentive stock options, and non-qualified stock options.  We discussed some of the reasons why companies issue them and the potential tax implications of ‘The Grant, ‘The Vesting’, and ‘The Exercise’.

In this article we will discuss another form of executive compensation, Restricted Stock Units.  We will discuss what happens at ‘The Grant’ and some of the tax implications associated with receiving restricted stock.  To provide clarity into the tax impacts we asked Julie Piché, with Foster Financial Group, LLC, to discuss two tax strategies associated with restricted stock, the 83(b) election and Section 1244.

Restricted Stock Units

Offered as a form of employee benefits, restricted stock can be given to an employee as a part of their compensation package or purchased from the company at a predetermined price.  In either scenario, restricted stock does not vest immediately.  Rather, similar to stock options, the stock units are vested over a period of time and are based on different performance milestones and/or upon remaining with a company for a pre-determined period of time.

At the time of grant the units are not assigned a value, and accordingly, are not taxable.  However, as the units vest they are then assigned a fair market value which is then realized as ordinary income to the holder of those shares.  Traditionally upon vesting, a certain number of shares are withheld to pay for the taxes on the entire vested group and the remaining shares are transferred to the employee.  At this point the employee can elect to sell the share immediately or hold the shares for potential future appreciation. If the stock is held for 12 months from vesting it qualifies for long term capital treatment.

Restricted stock also offers some interesting benefits to the individual, and potentially to the corporation under Internal Revenue section 1244 and 83(b).  To learn more we employ the help of Julie Piché with Foster Financial Group, LLC.

HRWM: Julie, how should investors and companies use Section 1244 and 83(b) for their benefit?

FFG:  Let’s start with the 83(b) election.

Section 83 b Election

As investors are granted restricted stock they should work with their tax advisor to learn how the 83(b) election could impact their future tax liability.  For those seeking to educate themselves first, the 83(b) election allows the investor to declare the stock value at the grant date, pay ordinary income tax, and essentially establish a tax basis of the stock on that date for future capital gains treatment when the stock is sold.  Because, ordinarily, the stock would not be subject to ordinary income tax treatment until the vesting date, this can considerably decrease the amount of ordinary income tax that would need to be paid.  Often, when restricted stock units are granted, the stock value is very low, and in some cases can be granted at a basis of zero, however basis will vary.  If ordinary income tax treatment is elected on this value by filing the 83(b) within 30 days of the grant date, then total taxes paid by the investor could be considerably less than if the vesting date is used to determine the ordinary income that would be taxable.

Using an example, if an individual is offered shares of stock in a start-up company as part of a compensation package, they have not necessarily paid anything for the stock.  Because there is not yet an established value to the company, an 83(b) election could be filed, setting the initial value of the stock at zero.  There would be no ordinary taxable income, and basis is established at zero.  In the future, if the company grows and the stock is sold for a large sum, the entire proceeds would now be considered capital gain, and would be taxed at a lower tax rate 

The rules for filing an 83(b) election have recently been simplified by the IRS.  An election must be filed within 30 days of the grant date.  In the past, you also had to attach a copy of the 83(b) election to that year’s tax return, which necessitated filing the return as a paper return, or remembering to attach a .pdf of the election to your electronically filed return.  This is no longer a requirement, which simplifies the filing of the election. 

Section 1244 Election

While the 83(b) election decreases taxation based on ordinary vs capital gain treatment of the proceeds of the sale of the stock, Section 1244 allows some special deduction rules in the case of losses with the sale of the stock.  Ordinarily, losses from the exchange or sale of a capital asset are treated as capital losses, and subject to the capital loss limitation rules.  This means that a large loss would either need to be used to offset other large capital gains, or it would have to be taken at a maximum of $3000 of loss per year until the entire loss was used up.  

Section 1244 stock losses are allowed to be treated as ordinary losses.  This could have huge implications for two reasons: First the losses could be taken in whole the year that the loss was incurred.  Second, the losses can be used to offset all ordinary income, rather than simply capital gain income.

There are specific rules that govern Section 1244 stock losses.  First, the ordinary loss cannot exceed $50,000 in a given tax year ($100,000 for a couple filing Married Filing Jointly).  In addition, to be classified as Section 1244 stock, the corporation must be a small business corporation, the stock must have been issued for money or other property (other than stock and securities) and the corporation (during the 5 most recent taxable years) must have derived more than 50% of its aggregate gross receipts from sources other than royalties, rents, dividends, interests, annuities, or sale and exchanges of stock or securities.

Let’s pull this apart.  To be considered a small business corporation, the aggregate amount of money and other property received by the corporation for its stock may not exceed $1,000,000.  These aggregate amounts would include all amounts received for stock, including and up to the time of the sale of stock for a loss.

The stock must have been issued for money or other property (other than stock or securities).  This means that when the stock was acquired, something physical changed hands – either in the form of physical assets (furniture, equipment, computers, etc) or actual cash.  If a liability is assumed by the stockholder when the stock is transferred, that is allowed to be deducted from the amount, or value, of the assets transferred.

Finally, with respect to the derivation of income, this mainly focuses the generation of income by the corporation to active trade or business.  Requiring that at least 50% of the income be generated from sources other than those named above focuses the earning into the realm of product sales, personal services income, or other actively generated income.

If all three of these criteria are met, and the stock is subsequently sold at a loss, then the losses can be taken (up to $50,000 for single or $100,000 for MFJ) as ordinary income losses.  If losses exceed these amounts, it is treated as attributable to a trade or business of the taxpayer for Net Operating Loss deductions according to Section 172.

Conclusion

If you just realized one these strategies might be something you should consider using then we strongly encourage you to consult with your tax advisor.  On the other hand, if you are more confused after reading this article then we want you to walk away with these points: 

  1. These rules exist to help investors in more risky situations.
  2. Both of these rules provide some benefit for taking a more risky investment approach, and can stimulate investment in start-up companies.
  3. Consult your tax advisor to understand how these, or other, tax strategies can be used to potentially reduce future tax liability.
  4. Lastly, from a holistic point of view, these strategies can be seen as supporting small business growth which in turn helps employment growth and the broader economy.

We hope you enjoyed learning about the difference between stock options and restricted stock.  To learn more consider scheduling a meeting with a Wealth Manager to have them assist you with your executive compensation.             

About Foster Financial Group, LLC

Foster Financial Group has been preparing tax returns for over 30 years for individuals, trusts, corporations and partnerships. All of their preparers acquire extensive continuing education each year, including attending the IRS convention every summer to receive the latest updates to tax law, rules, and regulations. They also offer the latest in technology and environmental friendliness, with electronic filing of every return, a secure, online portal for easy and safe two way document sharing, and .pdf versions of tax documents for those who are striving to eliminate paper files. They take great pride in explaining every line of the return to our clients, so that they understand everything they are signing and filing. Their partnership with their clients is of primary importance to their firm, and their commitment to them is a year-round availability with prompt return of communication, whether by phone, email, or appointment.

Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual.  The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete.

LPL Financial, and Horizon Ridge Wealth Management, LLC along with their advisors, do not provide tax advice.  Clients should consult with their personal tax advisors regarding the tax consequences of investing.

Julie Piché with Foster Financial Group, LLC, Horizon Ridge Wealth Management, LLC, and LPL Financial are all separate entities.

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