Section 83(a) of the Federal Internal Revenue Code (Title 26) is something you may never have heard of even if you work at a publicly traded company. However, it very well may have impacted your gross income and the taxes that you owed at the end of the year.
I am one of the many who was not familar with Section 83(a) of the IRS tax code before I started this post. I originally intended to write a post about restricted stock units (RSUs) and as I started my research I ended up deep in the bowels of the IRS tax code.
As I learned about Section 83(a) I realized that it has had an impact on my own life since I have had RSUs vest at multiple companies but never totally understood the source of some of the tax implications that come along with the vesting.
Web searches for information on Section 83(a) led me to some technical and legal articles on the subject. However, most of them failed to relay the information in a way that didn’t require re-reading the same paragraph five times. So here is my attempt to explain Section 83(a) in language we can all understand.
Disclaimer: I am not an accountant, tax attorney, IRS employee, or any other type of occupation from whom you should be getting personalized tax advice. This post is an attempt to break down part of the IRS tax code in a way that makes it understandable to others like myself. If you have any questions about how the tax code impacts your individual situation then please contact a tax professional for advice and guidance.
Some of the items that Section 83(a) applies to are RSUs, restricted stock, and non-qualified stock options (NSOs). Incentive stock options (ISOs) have different tax obligations so Section 83(a), as described below, does not apply to ISOs.
When RSUs and restricted stock shares vest and when NSOs are exercised after vesting there is an impact to your gross (taxable) income that in turn affects the amount of taxes you owe at the end of that tax year.
Straight From The Tax Code
In it’s true legalese beauty, Section 83(a) states
I.R.C. § 83(a)
…the excess of the fair market value of such property at the first time the rights of the person having the beneficial interest in such property are transferable or are not subject to a substantial risk of forfeiture, whichever occurs earlier, over the amount (if any) paid for such property, shall be included in the gross income of the person who performed such services in the first taxable year in which the rights of the person having the beneficial interest in such property are transferable or are not subject to a substantial risk of forfeiture, whichever is applicable.
Section 83(a) Explained
Straightforward enough right? Hardly. Let’s translate that block of text into something meaningful to the rest of us as it applies to RSUs, restricted stock, and NSOs.
…the excess of the fair market value of such property at the first time the rights of the person having the beneficial interest in such property are transferable or are not subject to a substantial risk of forfeiture, whichever occurs earlier,…
Translation: Take the price of the stock when the shares vest or the options are exercised and multiply it by the number of shares/options that vested/were exercised
Whenever shares granted through restricted stock units (RSUs) or restricted stock vest, or shares granted through stock options vest and are executed, that means that you can now sell those shares. That makes the shares (“the property”) “transferable” and “not subject to a substantial risk of forfeiture”. Basically, that means that the shares are now yours to keep.
…over the amount (if any) paid for such property,…
Translation: Subtract the cost basis of the shares/options from the previously calculated number
The cost basis is the amount the shares cost you at vesting/exercise. Note that for RSUs the cost basis may be $0. For options, the cost basis is the option price times the number of shares that you exercise.
…shall be included in the gross income of the person who performed such services in the first taxable year in which the rights of the person having the beneficial interest in such property are transferable or are not subject to a substantial risk of forfeiture, whichever is applicable.
Translation: The difference between the fair market value and the cost basis is added to your gross income for that tax year
Adding that amount to your gross income for that year means that at the end of the year you will owe taxes at your ordinary income tax rate (not the capital gains tax rate) on that “income.”
FI Road Tip: Note that you will be taxed on that additional gross income even if you do not sell a single one of those shares in the same year. If you hold onto the shares you’ll still pay taxes on the gross income amount. However, you will not pay any additional capital gains tax or recoup any capital losses until you sell.
Let’s work through a specific example.
Say you were granted 400 shares of company stock in a non-qualified stock option grant with an option price of $10.00 and the options vest 25% a year for four years.
At the end of the first year 100 shares vest. The stock price is now $15.00/share so you decide to exercise your options.
The difference between the current price and the option price is $5.00. Since you are exercising 100 options you would have $500 added to your gross income for that year in your W-2.
Come tax time if your tax rate is 20% you would pay $100 in federal taxes on that gross income even if you hold onto the shares.
|# of Options Granted
|4 years. Vesting 25% per year
|Stock Price When First 100 Options Are Exercised
|Exercise Price minus Grant Price
|Gross Income Added to W-2
|$500 ($5 * 100 shares)
|Federal Taxes Due @ 20% Tax Rate
FI Road Tip: At some companies when RSUs and restricted stock vests your company may withhold a certain number of shares for tax purposes based on the amount of additional gross income being added to your annual income. For example, if 30 shares vest, the company may only deposit 18 shares into your account, using the other 12 shares for tax withholding. It is unlikely to be the exact amount of taxes you will owe on that gross income, but it does mean that you do not have to remember to have money available to cover those taxes when you file your taxes at the end of the year.
Selling Your Shares
Now that you have the shares in your possession there comes the matter of selling them. You have a couple options, each with different tax implications.
Although this is unusual for people purchasing stock shares in traditional ways, selling the shares you immediately receive through restricted stock, RSU, and NSO vesting/exercises may be your best approach.
First, since Section 83(a) adds the difference between the fair market value and the cost basis to your gross income in that tax year you will owe what amounts to short term capital gains on that amount when you file your taxes. If you sell your shares as soon as you receive them you will not owe any additional capital gains taxes beyond the taxes you owe as part of the additional gross income that is tacked onto your W-2.
Second, you may be at a company that grants you additional restricted stock, RSUs, and/or NSOs on a regular interval such that as one block vests you receive a new block that starts its vesting period. Over time this can lead to you being over-leveraged in a single stock when compared to the rest of your portfolio. That increases the risk to your portfolio should your company’s stock experience a downturn. Selling the shares that vest/are exercised right away allows you to redirect those proceeds into your other, more balanced investment vehicles.
Buy and Hold
Of course, you may decide to hold onto your shares because you are confident that the stock is headed in the right direction and you do not feel that you are over-leveraged in the company. If you do buy and hold then there are two main implications.
First, if you did not have shares withheld to cover taxes at the time of vesting then you will need to have money available to pay taxes on the additional gross income added to your W-2 when you file your taxes. While it’s great to have $10,000 in RSUs vest or options get exercised, for example, if you are in a 20% tax bracket you need to be prepared to pay $2,000 in federal taxes on that amount (as well as any applicable state and FICA taxes).
Second, you will calculate capital gains or losses on the sale at the time that you choose to sell the shares. The next section deals walks through how to correctly calculate these gains/losses.
Calculating Gains/Losses When You Sell
Regardless of whether you sell your shares right away or hold onto them and sell at a later point you need to make sure you hang onto any documentation such as trade confirmations that you receive from your company when your shares vest/are exercised.
When you sell, you do not owe capital gains based on the original cost basis of the shares because you are paying/have paid taxes on the ordinary income added to your W-2 when the original vesting/exercising occurred.
The documentation you received when the shares vested/were exercised ensures that you’ll be able to calculate the correct cost basis for your shares so that you do not pay taxes twice on the difference between the fair market value and the original cost basis, once when the shares vested/were exercised and again when you sell the shares.
Let’s continue our example from above to see how selling works in a buy and hold scenario.
In the example, we exercised 100 options @ $15.00/share. Since our option price was $10 we had $500 (100 * $5.00) added to our gross income at the time we exercised our options and paid taxes on that additional income.
When we sell the shares 18 months later the stock price is now $21/share (woo hoo!). Since we held onto the shares for over a year we owe taxes based on our long term capital gains rate. But do we owe taxes on $600 in gains or $1,100 in gains?
In this example, we owe taxes on only $600 in gains based on our adjusted cost basis of $1,500. Since we already paid taxes on the additional gross income of $500 when the stock was at $15 and we exercised our options, that adjusted our cost basis from $10 to $15.
|Number of Shares Sold
|Stock Price When Options Were Exercised
|Adjusted Cost Basis
|$1500 ($15 * 100)
|Stock Price At Time of Sale
|Proceeds from Sale
|$2100 ($21 * 100)
|$600 ($2100 - $1500)
Restricted stock, RSUs, and NSOs are commonly used in compensation packages as incentives to retain employees and instill a sense of ownership in the company. If you have had, or will have, restricted stock or RSUs vest or NSOs exercised, hopefully this post has helped explain how Section 83(a) of the tax code is the reason behind that extra gross income that shows up in your paystub and the tax implications that come along with it.