Stock grants are one of the simplest and most flexible ways to provide employees a stake in their company. This is often done as a form of bonus compensation to incentivize key employees, particularly in early-stage startup companies, to reward employees for outstanding performance, or to recognize the importance of a key employee or new hire to the organization. These grants can either be "non-restricted" or "restricted."

• A non-restricted stock grant is an outright award of stock, usually given to key employees for achieving financial or strategic goals. This award is similar to a traditional cash bonus except that the award is in stock rather than cash.
• A restricted grant is an award that is tied to conditions that the employee must satisfy. The most common restriction is time-based vesting, which requires the employee to remain with the company for a certain length of time before full ownership of all of the shares is transferred. Departure prior to fulfilling the required service will result in the forfeiture of the unvested stock back to the company.

For stock grants that are not restricted, the tax implications are straightforward. For the employee, the fair market value (FMV) of the stock at the time it is granted is taxed as ordinary income. The company receives a tax deduction in an equal amount. The company is required to withhold income and employment taxes from the employee's pay.

A different set of tax rules applies to restricted stock grants. The employee is not required to recognize any income from the grant until the restrictions have lapsed and the stock is no longer "subject to a substantial risk of forfeiture" (that is, vesting requirements have been satisfied). At that point the employee would have to recognize the then-current value of the vested stock as ordinary income.

This tax treatment can present quite a problem for an employee who is granted restricted stock that rapidly appreciates in value. However, under Section 83(b) of the Internal Revenue Code, the employee can mitigate this problem by recognizing the restricted stock grant as income when the grant is received (even though the restrictions have not yet lapsed). With this election, the employee would pay taxes on the net value of the grant based on the fair market value of the stock as part of his or her taxable income for the year in which the grant is received. When the stock later vests, no additional tax payment is due from the employee. Instead, any increase in the stock's value since receipt of the grant will not be taxed until the employee sells the stock- and then it is taxed at capital gains rates, rather than as ordinary income. The net effect of a Section 83(b) election, then, is to convert all increases in the value of stock that has been granted to an employee to capital gain and to defer the payment of tax on that gain until such time as the employee sells those shares.

While the advantages of a Section 83(b) election are clear, such an election also creates some risk for the employee. If the employee should fail to satisfy the restrictions on the stock (for example, by terminating service before vesting requirements are satisfied), he or she will forfeit the unvested stock but will not be entitled to a refund of taxes paid. And if, after a Section 83(b) election is made, the value of the stock decreases and the stock is then sold, the decrease in value will be characterized as a capital, rather than ordinary, loss and be subject to the capital loss limitation rules.

The most appropriate situation in which to make a Section 83(b) election is when two conditions are present:

1. There is a strong likelihood of significant stock price appreciation
2. The individual has a high degree of confidence that he or she will remain employed with that company long enough to satisfy the vesting requirements.

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