Restricted stock grants provide employees with company stock that has restrictions regarding transfer and is subject to forfeiture. When the restrictions lapse, the stock becomes "vested" so that an employee owns the shares outright like any other shares of stock. Understanding these elements permits an employee to enjoy the benefits of stock grants and manage the tax consequences.
Receipt of Stock
An employee accepting a restricted stock grant must decide whether to pay tax on the value of the stock at the grant date or wait to pay tax on the stock value at the future vesting date. If an employee does not make a special tax election, the normal rule is that no income tax is due at the time of the stock grant. When the stock becomes vested, the fair market value on the vesting date---less any amount paid for the restricted stock---is taxed as compensation income in the vesting year.
The employer establishes a vesting period. The stock becomes vested with the employee when it is transferable without restriction and there is no risk of forfeiture. The stock is transferable when it can be sold, gifted, or pledged to anyone. Forfeiture exists when the restricted stock may be recalled by the employer should the employee fail to meet conditions of the employer's restricted stock plan. Common forfeiture conditions involve the employee continuing service to the employer for a specified length of time or meeting particular performance objectives.
By making the election for tax assessment in the year restricted stock is granted, an employee is taxed on the stock value at the time of grant. This election is made under Section 83(b) of the Internal Revenue Code. Any future appreciation in stock value will not be taxed as compensation income. No additional income tax is due at vesting. An employee may not revoke this election.
If the employee forfeits restricted stock after including its value as income in the grant year, the only tax loss is any amount paid for the restricted stock. The value taxed as compensation income is not recovered as a tax-deductible loss.
Dividends received on unvested restricted stock without a Section 83(b) election are taxed as compensation income. These dividends should be included on an employee's annual W-2. They should not be taxed a second time as dividend income.
Dividends received on restricted stock for which a Section 83(b) election was made are taxed as dividend income. These dividends are not reported as compensation income.
Sale of Stock
Upon the sale of unvested restricted stock for which no Section 83(b) election is made, the seller is taxed on the sale proceeds as compensation income in the sale year. For stock sold after the vesting period, there is a capital gain. If an election is made under Section 83(b), the holding period begins on the grant date. Otherwise the holding period begins on the vesting date. Stock sold with a holding period of one year or less is a short-term capital gain. Stock sold with a holding period of more than one year is taxed at a more favorable rate as a long-term capital gain. The gain is the difference between sale proceeds and basis. The basis is any amount paid for the stock plus the amount taxed as compensation income in the vesting year or---if there is a Section 83(b) election---in the grant year.
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