Restricted Stock Holding Period: When Does It Begin?
Understand how a key decision determines when your restricted stock holding period begins, directly impacting the tax treatment of your capital gains.
Restricted stock is a form of equity compensation where an employee is granted company shares that come with conditions. The most common condition is a vesting schedule requiring the employee to remain with the company for a specific period before gaining full ownership. Understanding the tax holding period is an important part of managing this type of compensation. The holding period determines if profit from a sale is taxed at higher short-term or more favorable long-term capital gains rates.
The Default Holding Period Rule
Under standard Internal Revenue Service (IRS) rules, the tax holding period for restricted stock begins on the date the stock vests, not the grant date. Vesting occurs when you fulfill the necessary conditions, like a service requirement, and gain full ownership. This rule is based on the concept of “substantial risk of forfeiture,” as the IRS considers the stock at risk of being forfeited until all restrictions are lifted.
When your restricted stock vests, a tax event occurs. The fair market value (FMV) of the shares on the vesting date, minus any amount you paid for them, is considered compensation. This amount is subject to ordinary income tax rates, and your employer is required to report this income on your Form W-2 and withhold the applicable income and payroll taxes.
The value recognized as ordinary income at vesting establishes your cost basis in the shares. To qualify for lower long-term capital gains rates, you must hold the vested shares for more than one year before selling them.
The Section 83(b) Election
An alternative to the default rule is the Section 83(b) election, which allows you to recognize the stock’s fair market value as taxable income in the year it is granted, rather than when it vests. The primary benefit is that the capital gains holding period also starts on the grant date. This can be advantageous if the stock’s value is expected to increase significantly before vesting.
This strategy has considerable risk, as you must pay taxes upfront on stock you do not yet fully own and could forfeit. If you forfeit the stock after making the election, the IRS does not allow a refund for the taxes you paid. The decision to make an 83(b) election is irrevocable.
To be valid, the election must be filed with the IRS within a strict 30-day window following the stock’s grant date, a deadline that includes weekends and holidays. You must send a completed election statement to the IRS service center where you file your taxes and provide a copy to your employer.
Tax Implications of Selling Restricted Stock
The decision to make a Section 83(b) election directly impacts how the sale of your stock is taxed.
Without an 83(b) election, you recognize ordinary income on the stock’s fair market value when it vests. For example, if 1,000 shares vest when the stock price is $10, you have $10,000 of compensation income taxed at your ordinary rate. This $10,000 becomes your cost basis. If you hold the shares for more than a year after vesting and sell them for $15 per share, your long-term capital gain is $5 per share, for a total of $5,000.
With an 83(b) election, you recognize ordinary income based on the stock’s value at the grant date. If you are granted 1,000 shares when the price is $1, you would recognize $1,000 of ordinary income immediately, which establishes your cost basis. If you later sell the shares for $15 after holding them for more than one year from the grant date, your long-term capital gain is $14 per share, for a total of $14,000.
The distinction lies in how appreciation is taxed. Without the election, any increase in value between the grant and vest dates is taxed as ordinary income, while with the election, that same appreciation is taxed as a capital gain.