TRULY THE BUBBLE SEEMS TO HAVE BURST or, at least, the air has been let out of the stock market.
Investors have been seen running for the cover of bond funds or money market funds. In the hey day of the market
build up of the late 1990's, employees of developing dot com and other start-up companies were often given stock
options instead of hard cash. Cash being a commodity which these start-up companies found lacking. These stock
options made millionaires out of many employees before they became thirty-somethings. In a very real sense, these
stock options were the corporate version of the homeowner's sweat equity. In this heady environment of instant
wealth, employees were also introduced to the taxman, who was about as welcome as the grim reaper and exacted about
as high a toll.
Because stock options usually involve large sums of money, they can be a source of instant wealth
but can also be a source of high taxes for the unwary. Stock options can be divided into two general groups:
Incentive Stock Options (ISOs) and all others. The ISOs receive favorable capital gain tax treatment if held for
the required period of time. However, they are not the focus of our discussion. This article covers a small window
of opportunity that exists with the other type of stock options. These options may be called Nonqualified Stock
Options. This type of stock option is often subject to some type of vesting provision or restriction on the right
to sell after exercise. For this reason, we will refer to these stock options as restricted stock. These restricted
stock options are taxable to the employee when the restrictions on them lapse and there is no significant risk of
forfeiture. They are treated as ordinary income and do not receive the favorable capital gains rates that the ISOs
Recipients of restricted stock may make an election [IRC Section 83(b)] to be taxed on the
compensation income now in order to qualify for capital gains treatment on any further appreciation in the stock's
price. Compensation income is the difference between the value of the shares at the exercise date and the price paid
to exercise the option. This income is subject to regular payroll tax withholding. Making this election may allow
you to pay less in taxes and to ultimately put more cash in your pocket. There are risks. There are rules.
As a recipient of restricted stock, you would want to make the Section 83(b) election when one or
more of the following situations exist:
- The shares have little or no value at the exercise date. This situation exists in many
- The exercise price is close to the fair market value. When this situation exists, the
employee would have little compensation income on which to be taxed.
- The stock price is expected to increase significantly by the time the restrictions on
the stock lapse. The election converts this increase in price from ordinary income to
capital gain income with its lower tax rate.
Conversely, you would not want to make this election when:
- You would have to recognize a large amount of ordinary income at the transfer date.
Only if further significant appreciation is expected would this be appropriate.
- The stock price will not appreciate or may even go down. If the stock price stays the
same, income is reported sooner than it would otherwise have been and at ordinary tax
rates instead of capital gain tax rates. If the stock price drops, not only is income
reported sooner but also more income is reported than would otherwise have been reported
and due to a special rule that exists under this election, the decrease in stock value
is not deductible.
- The employee will forfeit the stock before satisfying the restrictions attached to it.
Under these circumstances the only deduction allowed is for what the employee paid to
exercise the option.
Let's look at an example of the potential tax savings from making a Section 83(b) election.
Assume the following "facts:"
Sam has been granted the option to purchase 10,000 shares of stock at $10 per share. If Sam
leaves the company before three years after he receives the stock, he must sell it back to the company for the
price he paid for it. He plans to stay with the company and sell the stock in six years. Sam wants to exercise the
stock now; current fair market value is $20. Because of the number of shares and the appreciation that has already
taken place, Sam will be in the 39.6% marginal tax bracket and will be there also at the end of three years when
the restriction lapses and in six years when he plans to sell the stock. The capital gains tax rate is 20%. Lets
further assume that the stock will be worth $75 per share at the end of 3 years and $105 per share when it is sold
at the end of six years. An analysis of these facts and assumptions yields the following results (see inset box
Sam realizes $950,000 of income under both options (10,000 shares times the difference in value
at date of sale of $105 less the value at exercise date of $10). Making the Section 83(b) election saves Sam
$56,283. The NPV (net present value) of $566,376 at the exercise date of making the election ($58,950 + $507,426)
less the NPV of $510,093 at the exercise date of not making the election ($331,001 + $179,092). Sam's additional
tax savings were attributable to his ability to convert part of the rise in value from his marginal tax rate of
39.6% to the more favorable capital gains rate of 20%.
Remember the small window of opportunity that I mentioned earlier? Well, the Section 83(b)
election must be made no later than 30 days after the stock exercise date. It can be made before the exercise
date. In order to make the election, the taxpayer must file a statement with the Internal Revenue Service where he
normally files his tax return within the 30-day period. A copy of this election should be included with that
year's income tax return and also given to the taxpayer's employer. The taxpayer should get a signed copy
acknowledging receipt of the election statement by his employer. The election should include relevant taxpayer
information, a description of the property, restrictions applicable to the stock, and the amount paid for it.
Once made the election is revocable only with the permission of the IRS, which is only granted for mistakes of
For individuals willing to take a calculated risk in order to hang onto more of what should be
theirs, the Section 83(b) election may be the means to that end. All it takes is the option to own restricted
stock, the belief that that stock will appreciate, calculating the benefit from making the election based on your
specific circumstances and taking action within 30 days of exer-cising your option. This is where your favorite
CPA can help. Enlist him in your fight to keep what is yours. He will be up-to-date on all the requirements to make
the election stick. Then sit back, relax and pray for that increase in your stock's value.