Though the glamour surrounding stock options and other share-based compensation dissipated with the bursting of the tech bubble at this millennium’s outset, these employee incentives are still in place for many executives. Few of these executives, however, understand the special tax treatments associated with stock option and restricted stock grants. Kellogg School of Management’s Professor Robert McDonald has rigorously examined the optimal timing of tax payments on options and stock grants in his 2003 paper entitled “Is it Optimal to Accelerate the Payment of Income Tax on Share-Based Compensation?” In this paper he demonstrates the error in the common belief that it is generally optimal from a tax perspective to exercise these stock options and restricted stock grants early when the underlying stock is expected to appreciate in value.

The basics of option grant and restricted stock taxation are as follows: in the case of an option, its value is typically taxed as ordinary income when the option is exercised. If the employee decides to hold on to the stock after exercise, future gains or losses are taxed at the more favorable capital gains rate. In the case of restricted stock grants, these grants are taxed as ordinary income when they vest. However, the owner of the grants can make a Section 83(B) election when the restricted stock is granted. The taxpayer then pays ordinary income tax on the value of the stock at the time of the grant, and pays a lower capital gains tax on the stock’s capital appreciation when it vests. Figure 1 illustrates the tax liability scenarios described above: when employees take full ownership of options by exercising them or are granted restricted stock compensation, any gain to that point is taxed as ordinary income; subsequent gains or losses in the stock’s value are taxed at a lower capital gains rate.

Figure 1: Taxation on Share-Based Compensation

Section 83(b) elections
Under the U.S. Internal Revenue Code of 1986, an employee or service provider can choose to be taxed for restricted property, including restricted stock grants, in the fiscal year in which the grant was made rather than waiting until the restrictions lapse (i.e., the stock shares vest). The recipient must file the election within thirty days after the grant is received. The stock grant is then taxed based on the fair market value of the shares at the time they are granted, subtracting the amount paid for them, if any. For restricted stock grants, companies can require or prohibit employees from making an election.