Restricted Stock and IRS Tax Problems: Understanding The Issues

Restricted stock is company stock which a corporation gives to an employee. The restriction means that the stock cannot be sold until sometime in the future.


A new corporation (think of any tech start-up, really) typically has great growth potential but little cash. It probably has terrific young people who put in long hours and who are making the company succeed. The company does not have money for large cash bonuses, but it does have a lot of stock.


The company would like to make sure that the terrific talent do not jump ship and go somewhere where the pay is better. Thus, it gives the staff restricted stock along with an agreement that specifies when the stock will vest and a requirement that the employee remain with the firm until the vesting date.


What does that mean?


Once the employee meets the vesting requirements, the stock is no longer restricted and the employee can sell it. The payoff can be great. For example, in 2003 the company gave the employee 3000 shares of stock. The company values the stock at par value or $.01 per share making the stock worth $30.00. That is not much of a gift. Five years later when the stock vests, it is worth $15 per share. 3,000 times $15 is $45,000.


There is a problem, however. It is a great gift but gifts are taxed as ordinary income. That means the employee has to pay both federal, state and payroll taxes on the $45,000 and the company has to pay its share of payroll taxes as well. The stock has not been sold and so the employee has to pay taxes on money he has not received. That doesn’t sound so good. The employee has $45,000 worth of stock for which he has not paid one dime. Here is where it gets good – The company continues to profit and the stock not only goes up in value but splits as well. In 2008 the stock has split so that the employee now has 15,000 shares and the stock is priced at $30 per share. It is time to cash in, and so 15,000 shares at $30 per share yields $450,000. Sounds great, but what about the taxes? Remember that the employee paid taxes on $45,000 in 2005.


The IRS considers that as the purchase price of the stock and the difference between the sales price and the $45,000 or $405,000 is taxed as a capital gain.


Does that make a difference?


Well, $405,000 taxed at 35 percent is $141,750. $405,000 taxed at the ObamaCare/Capital gains rate is $72,900.


But wait — there is a provision in the tax code known as the 83(b) election. By that you can agree to have the stock taxed on its value as of the date it was awarded.


If the employee had done so, he would have paid tax at the ordinary income rate, on the $30.00. When he sold, the capital gain would have been on the difference between $450,000 and $30 or $449,970. The capital gains tax would be $80,994. The ordinary income tax on $449,970 would be $257,489.10.


A 83b election may not be  your only move


Earning a large return on restricted stock may be a once-in-a-lifetime opportunity. The larger the gain, the more elegant and sophisticated tax strategies present themselves. We always invite individuals who have doen well to investigate Private Placement Life Insurance. It is not for everyone, but when it does work, it works increbily well, especially for those livign in high tax jurisdicitons like California.


If you need any assistance deciding on the best plan of action, contact us for a complimentary tax planning session.