Planning Ideas—Section 83(b) Election

Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NQSOs) continue to be valuable elements of executive compensation packages. However, in recent years, with stock prices challenged in a recovering economy, many employers have favored traditional cash and/or stock bonuses tied to objective and palatable performance goals over stock options. These restricted stock awards offer benefits to both employers and executives, but like stock options require care in planning.

Restrictive Stock Awards
From the employer’s perspective, one benefit of these awards is that like stock options they do not require a cash outlay. Furthermore, because they are incentive-based these plans are not subject to IRC Section 162(m), which generally limits a public company’s compensation deduction with respect to its top executives to $1 million per executive per tax year. Finally, by conditioning vesting of awards on achievement of long-term performance goals, employers “hand-cuff” employers to the company and assure continuity of management and deeper executive bench strength.

From the executive’s perspective, restricted stock grants are attractive because they are, generally, not taxable as compensation until they vest. In addition, they require no “up-front” out-of-pocket commitment from the executive while allowing him or her to acquire equity ownership of the company.

Income Tax Consequences
For tax purposes, the executive does not recognize any tax at the time of the grant of the restricted stock; however, when the restrictions lapse, the executive recognizes ordinary income equal to the bargain element associated with the restricted stock. The bargain element is measured by the difference between the fair market value at the date the restrictions lapse and the amount paid for the stock, if any.

From the employer’s perspective, a tax deduction is, generally, available only when the executive recognizes the bargain element as ordinary income. The amount of the deduction is limited to the amount included in the executive’s income.

IRC Section 83(b)
IRC Section 83(b) offers an alternative to application of the usual tax rules. Under this provision, the executive pays taxes including the bargain element in income when the restricted stock is awarded, not when the restrictions lapse.  The employer is allowed a deduction at the time of grant when the executive makes the 83(b) election.

One advantage of the Section 83(b) election to the executive includes paying tax on at a time when the stock price is expected to be lower than in the future.  A second advantage is that post-83(b) election appreciation is eligible for long-term capital gain when the stock is sold.
The disadvantages of the Section 83(b) election to the executive are:

• If the value of the stock price stays flat, the 83(b) election accelerates inclusion of income;
• If stock price goes down, the executive will have paid more tax than necessary; and
• If the recipient forfeits stock received under the grant (due, for example, to termination of employment within the prescribed time or failure to achieve performance goals), he or she cannot recover the taxes paid attributable to compensation declared under the Section 83(b) election.

The Advisor’s Role
Here are some basic guidelines for Advisors to follow when discussing the IRC Section 83(b) election with clients.

Section 83(b) is advisable when:

• The amount of income reportable under Sec. 83(b) election is small;
• The potential stock appreciation is great; and
• The value of the stock is expected to increase with little likelihood of forfeiture.
• Consider the following example:

Davis is granted 10,000 shares of restricted stock when the fair market value of the stock is $10.00 per share, the purchase price is zero, and the shares vest 100 percent after four years. Davis remains with the company and sells the stock when its value quadruples to $40 per share.

The following table illustrates the trade-offs inherent with a Section 83(b) election.

#1—Tax Effects at Grant

#2—Tax Effects at Vesting

#3—Tax and Cash Flow Effect at Sale Example

Please Note: the 40 percent state and federal income tax rate is for illustrative purposes only.

In this case, the executive comes out $75,000 ahead with the Section 83(b) election.

Bottom Line
Taxes are not the sole factor to consider when planning for executive compensation, but knowing how to advise clients on when to make a Section 83(b) election can make a big difference. Don’t overlook this opportunity to serve your clients.

Disclaimer: The materials and information contained herein are intended for educational purposes, to stimulate thought and discussion so as to provide the reader with useful ideas in the area of wealth management planning.  These materials and information do not constitute and should not be considered to be tax, accounting, investment, or legal advice regarding the use of any particular wealth management, estate planning, or other technique, device, or suggestion, nor any of the legal, accounting, tax, or other consequences associated with them. 
While the content herein is based upon information believed to be reliable, no representation or warranty is given as to its accuracy or completeness.  For this reason, the program of study should not be relied upon as such.  Although effort has been made to ensure the accuracy of these materials, you should verify independently all statements made in the materials before applying them to your particular fact pattern with a client.  You should also determine independently the legal, investment, accounting, tax, and other consequences of using any particular device, technique, or suggestions, and before using them in your own wealth management planning or with a client or prospect.  Information, concepts, and opinions provided herein are subject to change without notice.
The strategies contained within these materials may not be suitable for all clients.  For many concepts discussed herein, clients are strongly urged to consult with their own advisors regarding any potential strategy and will need to strategy described herein is suitable for their particular circumstances.
Examples, provided throughout these materials, are for illustrative purposes only, and no representation is being made that a client will or is likely to achieve the results shown.  The examples shown are purely fictional and are not based upon any particular client's circumstances.