Guidance on tax rules for stock grants or awards.
If you work for a corporation, you may receive compensation in the form of stock of that corporation (or perhaps the parent of that corporation). If the stock is vested when you receive it, you have to report compensation income at that time. Otherwise the stock is restricted, and you won’t report compensation income until the stock vests.
Terminology: Various terms we use in this area are interchangeable. Stock is vested when there’s no risk of forfeiture. When we say stock is restricted, we mean it isn’t vested — in other words, there is a risk of forfeiture.
We’ll take you through the rules for grants of vested stock, then explain the rules for restricted stock.
In general your stock is vested if you can quit your job — or be fired — without losing some or all of the value of your stock. For more details on what it means for stock to be vested, see When Stock Is Vested. Here are the rules that apply if your stock is vested when you receive it:
Receiving vested stock
If your stock is vested when you receive it, you have to report compensation income equal to the value of the stock on the date of the grant or award. That’s true even if you don’t sell the stock, so you haven’t received any cash.
Example: Your employer awards you 250 shares of stock worth $40 each. On your income tax return for that year you must report $10,000 of compensation income because of this award.
If you’re an employee, the company has to withhold on the value of the vested stock you received. The value of the stock, and the amount withheld, will be included in your Form W-2.
The employer can satisfy the withholding obligation by withholding an extra amount from your cash compensation — or by requiring you to deposit the amount of withholding in cash at the time of the grant. The income tax portion of this withholding will be a credit on your income tax return for that year, just like regular income tax withholding from your cash wages. Be prepared: the withholding may not be enough to cover the full amount of tax due as a result of the stock grant. The amount withheld is just an estimate of the tax that will be due on this income; your actual tax may be higher. Details: Withholding on Stock.
If you’re not an employee, there shouldn’t be any withholding in connection with the stock grant. You may have to make payments of estimated tax to avoid a penalty at tax time. (See Guide to Estimated Taxes.) Because the stock is received for services, this income is subject to the self-employment tax.
Basis of the stock
Your basis in the stock is equal to the amount you paid for it, if any, plus the amount of income you reported in connection with the stock grant. Generally the sum of these numbers is the fair market value of the stock. Your basis doesn’t include the tax withholding, even if you had to pay that amount out of pocket to receive the stock.
Sale of the stock
When you sell the stock you’ll report capital gain or loss, depending on whether the amount you receive is larger or smaller than your basis in the stock. The gain or loss will be short-term is you held the stock one year or less at the time of the sale. You need to hold it at least a year and a day to have a long-term capital gain.
Receiving restricted stock
The rules that apply when you receive stock that isn’t vested are quite different. Generally you aren’t treated as the owner for tax purposes until the stock vests. That’s both good and bad. You don’t have to pay tax at the time you receive stock that’s not vested. But the amount of tax you pay later when it vests can be significantly higher. If you think you would be better off under the rules for vested stock, you can elect to use those rules, but you have to file the election within 30 days after receiving the stock.
You may have ownership rights for the stock even though the tax law doesn’t treat you as an owner. For example, unless you’ve agreed otherwise you’re entitled to vote the stock you receive as an award even if it isn’t vested.
No tax when you receive stock
If the stock you receive as compensation isn’t vested when you receive it, you’re not required to report income at that time. Your employer won’t withhold or report anything either. Unless you make the Section 83b Election, it’s as if nothing happened at that time.
Treatment before vesting
As far as the tax law is concerned, you don’t own the stock before it’s vested. That means that any dividend paid on the stock during that period can’t be a treated as a dividend. Instead, the dividend is treated as compensation paid to you by the company. You should see this income on your Form W-2, not a Form 1099-DIV.
Income when stock vests
When the stock vests, you’re required to report compensation income equal to the fair market value of the stock. The fair market value is determined as of the time the stock vests.
Example: You receive 1,000 shares of stock at a time when the value of one share is $20.00. The stock vests a year later when it’s worth $35.00 per share. You’re required to report $35,000 of compensation income at that time.
This income is subject to withholding if you’re an employee, and should be reported on your Form W-2. Because no cash is being paid at this time, withholding (and any tax not covered by withholding) must be paid from other resources.
Warning! Tax Pain Ahead! It’s important to focus on the consequences of the rule explained above. During the period you’re waiting for your stock to vest, any increase in the value of the stock is going to result in ordinary compensation income, not capital gain. In many cases it makes sense to consider the Section 83b Election as a way to avoid this result.
Basis and holding period
For the period before the stock vests, your basis is equal to the amount you paid for it, if any. In other words, if you didn’t pay anything for the stock, your basis is zero. After the stock vests, your basis includes the amount you reported as income when the stock vested (in addition to the amount you paid for the stock, if any).
Example: You received a grant of restricted stock and didn’t make the section 83b election. When the stock vested it was worth $27,000 and you reported that amount as compensation income. Your basis is the stock is $27,000, so you would report only $1,000 of gain if you sold it for $28,000.
For tax purposes your holding period for the stock begins when it becomes vested. You need to hold the stock at least a year and a day after the vesting date to qualify for a long-term capital gain when you sell it.
Example: You received a grant of restricted stock and didn’t make the section 83b election. The stock vested a year later, and nine months after that you sold the stock. Although you actually held the stock 21 months, for tax purposes you only get credit for holding it nine months. Any gain or loss on the sale will be short-term.
Section 83b election
If you make the section 83b election, your stock will be treated as vested stock even if it’s restricted. This election isn’t always a good idea, but in some cases it’s a big tax-saver. For details see Section 83b Election.