Executive Compensation Planning: A Practical Guide to Designing and Protecting Executive Pay, Part 2: Equity Compensation – From Restricted Stock to the 83(b) Election
In Part 1, we introduced the executive compensation landscape and examined incentive stock options (ISOs) and nonqualified stock options (NQSOs). Now we turn to other forms of equity and equity-like compensation, including the critical Section 83(b) election that can dramatically affect an executive’s tax outcome on restricted stock awards.
For executives and companies alike, understanding the differences between these instruments, and the tax elections available, is essential to maximizing after-tax value and avoiding costly mistakes.
Restricted Stock and Restricted Stock Units (RSUs)
Restricted stock involves an actual transfer of shares at grant, subject to vesting conditions and forfeiture restrictions. Under the default rule, the executive recognizes ordinary income when restrictions lapse, based on the stock's fair market value on the vesting date. An executive who wants to start the capital gain holding period earlier may file a Section 83(b) election within 30 days of the transfer, electing to recognize income at grant based on the stock's then-current value. The 30-day deadline is absolute. There are no extensions, and the opportunity cannot be recreated once the window closes.
RSUs are a promise to deliver stock upon vesting. Because no property transfers at grant, no 83(b) election is available. Ordinary income is recognized at delivery. RSUs that settle promptly upon vesting may qualify as short-term deferrals under Section 409A; RSUs allowing deferred settlement must comply with Section 409A's full requirements.
Phantom Stock and Stock Appreciation Rights
Phantom stock and SARs allow companies to deliver equity economics (value tied to the company's stock price) without issuing actual shares. This makes them particularly attractive for private companies, S corporations, and family businesses that want to incentivize key executives without diluting ownership or creating new equity holders.
Phantom stock units track the value of a notional company share. Full-value units entitle the executive to the full per-share value at settlement; appreciation-only units pay only the value increase above the grant date price, making them functionally equivalent to a SAR. All amounts received are taxed as ordinary income; no capital gain treatment is available because no actual equity changes hands. The employer receives a corresponding deduction at payment.
Section 409A applies to phantom stock and SAR arrangements that do not qualify as short-term deferrals. Plans permitting deferred payment must specify permissible payment triggers, prohibit accelerations, and comply with all other 409A requirements.
The 83(b) Election: A Narrow Window, a Significant Consequence
For any executive receiving restricted stock, the 83(b) election is among the most consequential, and time-limited, decisions in executive compensation planning. Filing the election within 30 days of the stock transfer allows the executive to recognize ordinary income at grant based on the stock's current value, which at an early-stage company may be minimal or effectively zero. If the stock later appreciates, the growth is taxed at long-term capital gain rates rather than as ordinary income.
The risk is real: if the executive forfeits restricted stock after filing the election (by leaving before vesting, for example) the previously recognized income cannot be recovered as a tax deduction. The election is a bet on future appreciation and continued employment. Both the upside and the downside should be modeled carefully before the 30-day window closes.
Next in Part 3: Nonqualified deferred compensation, SERPs, and Section 409A, the rules that govern virtually every deferred compensation arrangement.
DISCLAIMER: This summary is not legal advice and does not create any attorney-client relationship. This summary does not provide a definitive legal opinion for any factual situation. Before the firm can provide legal advice or opinion to any person or entity, the specific facts at issue must be reviewed by the firm. Before an attorney-client relationship is formed, the firm must have a signed engagement letter with a client setting forth the Firm’s scope and terms of representation. The information contained herein is based upon the law at the time of publication.