When companies award employees stock, the gift comes with certain restrictions. Deffered stock and restricted stock are interchangeable terms; employees defer selling the shares during the restriction period. This is called the vesting period, during which employees don’t own the stock outright. An employee selects an income tax treatment at the time restricted stock is granted. The choice affects tax consequences after the restrictions lapse.
Tax at Grant
By making an election under Section 83(b) of the tax code, the value of stock at the time of the grant is added to an employee’s taxable compensation. None of the funds needed to pay the tax are available from the stock because selling shares is restricted.
During the vesting period, when the sale of shares is deferred, an employee must forfeit any restricted company stock if his employment is terminated. In this scenario, the value taxed at the time of the grant is never recovered.
Tax at Vesting
After the vesting period an employee no longer risks forfeiture and may sell the stock without restriction. No additional income tax is assessed upon vesting if an employee made an 83(b) election. However, if there was no 83(b) election at the time of the stock grant, income tax is assessed when the shares are vested. The stock value on the vesting date is taxed as employee compensation. Although a higher stock value after the grant date increases the tax assessment, an employee has the ability to raise cash to pay the tax by selling shares.
Selling stock after vesting produces capital gains that amount to the difference between the sale proceeds and the amount already taxed as employee compensation. The holding period for restricted stock begins when the employee elects tax assessment as compensation. For an 83(b) election, that’s the grant date. Without an 83(b) election, the holding period starts on the vesting date. Stock sold more than one year after the holding period starts is taxed at the favorable long-term capital gains rate.
An employee is entitled to receive dividends on restricted stock even during the vesting period when the sale of shares is deferred. Dividends on unvested stock without an 83(b) election are taxed as employee compensation. They are added to the employee’s W-2. However, when an 83(b) election is made, the dividends are taxed just like dividends on unrestricted stock. This allows treatment as qualified dividends, which are taxed at the capital gains rate instead of the higher tax rate for compensation income.