Goodbye stock options, hello common stock: companies are returning to the tried-and true grant of common stock.

• Author: Hudson, Boyd D.
• Position: TaxImplications

As the memory of the technology boom fades, so does the once ubiquitous employee stock option. Large publicly traded corporations are no longer granting stock options to their employees for several reasons.

First, many stock options are now under water with the trading value far below the exercise price. Second, the issuance of stock options has been criticized for focusing on short-term stock performance to the detriment of non-employee shareholders. And third, there is increasing pressure from the accounting profession and securities regulators to expense employee stock options, once thought of as a no-cost means of attracting talent to entrepreneurial startups.

RESTRICTED STOCK IS IN

In lieu of stock options, companies are returning to the tried-and-true grant of common stock as part of an employee's compensation package.

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Frequently, the stock will be subject to restrictions, such as the employee's continued employment, or will be tied to the company's performance. However, granting restricted stock presents both tax opportunities--and pitfalls--for the company and the employee.

AN EXCEPTION TO THE RULE

As a general rule, an employee who receives payment for the performance of services, whether in cash or in property, must include the payment in gross income. This includes the value of employer stock.

Section 83(a) of the Internal Revenue Code addresses the taxation of property transferred in connection with the performance of services. But there is an exception to immediate recognition: Income recognition is deferred or postponed if the property is restricted. In tax parlance, property is restricted if it is "subject to a substantial risk of forfeiture."

For example, an employee receives stock that he must forfeit unless he continues to work for the company for a minimum period of time. When this requirement is satisfied or other restrictions lapse, the employee will then recognize the value of the stock as compensation income. If the employee violates the restrictions and the stock is forfeited, there is no income recognition.

TIM'S XYZ RESTRICTED STOCK

As an example, XYZ Corp. sells 1,000 shares of XYZ common stock to its employee, Tim, for $1 per share. The fair market value of the stock on the sale date--Jan. 2, 2003--is $4 per share. The stock is restricted in that Tim forfeits all rights to the shares if he leaves XYZ before Jan. 2, 2007.

If he leaves the company before that date, XYZ will repurchase the shares, but only for the amount Tim paid for them. As a result, Tim will forfeit any appreciated value in the shares, but for tax purposes he will not recognize any compensation income as part of the transaction.

Assume that Tim is still employed at XYZ on Jan. 2, 2007 and the restrictions lapse. If the XYZ stock is then worth $20 per share...