Sometimes stock is received as payment for services rendered. Your basis in the stock is the market value of the stock received (which you also must declare as taxable income.)
"Basis" is the word used for your cost for tax purposes, after adjusting for various events and rules.
However, if the stock has restrictions on its transferability, has a substantial risk of forfeiture, or is not fully vested until a later date, you do not have to include it in your compensation income until the restrictions are removed.
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You have no tax basis in the stock until you declare income on your tax return for the receipt of the restricted stock, and the date the restrictions are lifted becomes your acquisition date.
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You do have the option to elect to be taxed for the value upon receipt of the restricted stock award (but not restricted stock units) rather than waiting until the restrictions are removed. It's called a Section 83(b) election and it's an irrevocable election (that means you can't change it without IRS permission.) How do you make this election? You must file a written statement with the IRS at the address where you file your income tax return. The statement must be filed within thirty (30) days of receipt of the restricted stock. The statement must specify all of the information below:
1. Statement that you are electing to make an election under IRC Section 83(b) to be taxed on the fair market value of restricted property received before the property becomes substantially vested or transferable, i.e., before the restrictions are removed.
2. Taxpayer name, address, and identification number.
3. Description of the restricted stock property.
4. Date(s) of transfer and tax year which applies.
5. Nature of the restrictions on the stock.
6. Fair market value of the stock at the time of transfer to you.
7. The amount you paid for the property, if any.
8. A statement affirming that you have provided copies of the statement to any person for whom you performed services and to any other person that received the restricted property in place of you.
Why would you even want to do this--pay income taxes earlier than required? Because if you receive restricted stock in a highly appreciating entity (think Facebook), you would be much better off declaring compensation at a lower amount now and then paying only capital gains taxes later on the subsequent appreciation. The compensation is subject to ordinary income tax rates, while the capital gains tax rate is substantially lower.
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The IRS recently issued taxpayer guidance for Section 83(b) elections in a Revenue Procedure, including examples and a sample election statement. The election statement can be downloaded by clicking the "Word document" icon shown. For our readers who like to dig into the details, the full text of IRS Revenue Procedure 12-29 is also available for download by clicking the "pdf" icon.
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Section 83(b) Election Statement |
IRS Revenue Procedure for Sec 83(b) Elections |
WHAT HAPPENS WHEN I SELL RESTRICTED STOCK?
It depends on: (1) whether you made an Internal Revenue Code (IRC) Section 83(b) election, and (2) whether you sold the stock to a related party or not.
IRC Section 83(b) election: If you made the election to pay income tax early, your basis is the compensation income you declared plus any amount you paid for the stock. Your capital gain is the amount of the sales proceeds less your basis.
Arm's-Length Sales: If you sell the restricted stock before it is substantially vested, your basis for capital gains purposes is the amount of the sales proceeds, but you must also declare the same proceeds (less any amounts you paid for the stock) as compensation income. Your capital gain is zero. The sale must be made in an arm's-length transaction and not to a related party.
Related Party Sales: If the sale is made to a related party, in the year of the sale you follow the same steps as for arm's-length sales described above. However, there is an additional requirement that when the stock becomes substantially vested, you must declare the difference between the current market value and the earlier reported sales proceeds as compensation income. There is no adjustment made to the capital gain of zero that you reported in the prior year. This in effect penalizes the shareholder and family member because additional basis is taxed, but no one gets to claim the additional amount of basis for capital gain purposes.
HOW DO I REPORT THIS ON MY TAX RETURN?
WHAT HAPPENS IF I FORFEIT THE STOCK?
If you paid tax early using the IRC Section 83(b) election, your loss upon forfeiture is only the amount you paid for the property less the amount you realized on the forfeiture, if any. You do not get to claim any basis for the amount you declared as taxable income!
If you did not pay tax early, there would be no taxable event if you forfeit the stock. You have no sales proceeds and no basis. The tax effect is zero.
The discussions above do not refer to stock options, which have different rules and are covered elsewhere.
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