Tax aspects of restricted stock and stock options.

• Author: Hall, C. Wells, III
• Position: The 2002 Law Journal

Equity-based compensation is often used to attract, retain and motivate key employees in lieu of substantial cash compensation. In a public corporation, it is used to get key employees to perform in a manner that will cause the value of the stock to increase in the public market. In closely held corporations, stock compensation may have less value if there is no market in which to sell it. Sometimes its value to the key employee lies in the promise or hope of a sale of the company, a public offering of its stock or a price determined by a buy-sell agreement. Equity-based compensation may be structured to provide tax advantages of the employee based upon the differential between the maximum tax rate on net long-term capital gains, now 20%, and the maximum tax rate on earned income, 39.1%.

Restricted stock and Section 83

When an employer grants stock subject to restrictions, the employee is taxed under Section 83 of the Internal Revenue Code when the stock becomes transferable or is no longer subject to substantial risk of forfeiture. Its value is determined without regard to any restrictions other than nonlapse restrictions. Property is subject to a substantial risk of forfeiture if rights to its full enjoyment are conditioned upon performance of substantial services. An example would be selling stock to an employee for a nominal price on condition that it be returned at that same price if the employee fails to remain with the employer for a specified period.

If stock is subject to a substantial risk of forfeiture, the employee can file an election under Section 83(b) to treat it as if it is vested for federal income-tax purposes when it is transferred. The employee is taxed upon receipt for its excess value, without regard to the forfeiture restriction, over the amount he paid for it. This makes sense if the value is expected to appreciate substantially. However, it accelerates payment of the tax. The employee must file a statement with the IRS electing Section 83(b) treatment within 30 days of the transfer and must also give a statement to the employer.

* Example 1: On June 1, 2002, Employee A receives company stock that has a fair market value of $50,000. He pays $30,000 for it. If he leaves the company within two years, he is required to return the stock to the company for the lesser of $30,000 or its fair market value at that time. He does not recognize any income at receipt of the stock. On June 1, 2004, when the stock becomes vested...