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Restricted stock: The Tax Impact On Employers and Employees - Part 1 of 4

G. Edgar Adkins, Jr., and Jeffrey A. Martin of Grant Thornton LLP


Restricted stock is growing in popularity as a method to compensate employees, primarily as a result of changes in generally accepted accounting principles (GAAP) that went into effect in 2006. An important aspect of this compensation tool is the income tax treatment, from both a corporate (i.e., employer) and individual (i.e., employee) perspective. The discussion below addresses not only the direct tax treatment - i.e., the recognition of income by the employee and the deduction by the employer - but also related tax issues. These include the effect of restricted stock on the $1 million deduction limit that applies to public companies under Section 162(m) and the treatment of restricted stock in determining eligibility for S corporation status.

Overview

"Restricted stock" refers to stock that is transferred to an employee as compensation for services, subject to a vesting schedule.[1] The employee usually is not required to pay for the stock. If the employee does not remain with the employer until the end of the vesting period, the stock must be returned to the employer. If the employee has paid any amount for the restricted stock but then fails to become vested, the employer usually refunds the purchase price to the employee

"Restricted stock" sometimes is used interchangeably with "restricted stock unit." While similar, there is one major difference. With restricted stock, the stock itself is transferred to the employee, subject to a vesting schedule (as noted above). With restricted stock units, the stock is not transferred to the employee until the stock becomes vested. Thus, a restricted stock unit is a promise from the employer to transfer the stock on the vesting date. The tax treatment of restricted stock and restricted stock units, discussed below, is the same except where differences are specifically noted.

Until a change in accounting standards that went into effect in 2006, employers were permitted to use Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (1972) (APB 25), to measure compensation cost reported in their income statements. APB 25 used the intrinsic value method to measure compensation cost associated with stock issued to employees.[2] Stock options were particularly popular under APB 25, because the intrinsic value of most options was zero, resulting in no compensation cost recognized on the income statement. The following formula was used to measure the intrinsic value of stock options:

Fair market value of the stock on the date the option was granted
Exercise price of the option______________________________
Intrinsic value of the option

Most employers issued options that had an exercise price equal to the fair market value (FMV) of the stock on the option's grant date; thus, the intrinsic value was zero, and no compensation cost was recognized.

The same basic formula was used to measure the intrinsic value of restricted stock, as follows:

Fair market value of the stock on the date the restricted stock was granted
− Purchase price paid by the employee (often zero)____________________
Intrinsic value of the stock

Since employees did not typically pay for restricted stock, the intrinsic value of restricted stock was generally the FMV of the stock on the grant date, resulting in compensation cost equal to the FMV. Consequently, restricted stock produced a less favorable accounting treatment than stock options, so stock options were considerably more popular than restricted stock.

In 1995, Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation (SFAS 123), went into effect, requiring employers to disclose the value of equity-based compensation, such as stock options and restricted stock, in the footnotes of their financial statements. For this purpose, the value of stock options could no longer be measured by the intrinsic value; instead, the value had to be calculated by using a stock option valuation model such as Black-Scholes. The value of restricted stock continued to be the stock's FMV as of the grant date, reduced by any amount paid for the stock by the employee. Employers could voluntarily record the disclosed amounts associated with stock options as a compensation cost in the income statement but few chose to do so. Instead, on their income statements they continued to account for stock options and restricted stock under APB 25. As a result, stock options continued to be the most popular form of equity-based compensation.

A 2004 revision of SFAS 123, Share-Based Payment (SFAS 123(R)) went into effect in 2006. Under SFAS 123(R), companies must now record the value of stock options as a compensation cost on their income statements.[3] Accordingly, stock options no longer enjoy the significant advantage over restricted stock of no cost recognition. This has caused many companies to take a closer look at restricted stock as a viable compensation tool. As a result, restricted stock has increased in popularity, while the popularity of stock options has declined.

Restricted stock serves several useful purposes as a compensation tool. First and foremost, the vesting schedule serves as an incentive for the employee to remain with the employer. In addition, the potential for future appreciation in the stock's value serves as a powerful performance incentive.

More often than not, an employee is not required to pay for restricted stock. Thus, the full value of the shares accrues to the employee on vesting, and the shares have value even when the value declines between the grant date and the vesting date. This is very different from stock options, where there is no value to the employee unless the stock appreciates in value. As a result, a share of restricted stock has more value than a stock option. Accordingly, employers who issue restricted stock rather than stock options are able to use fewer shares to provide the same value to employees. The fact that restricted stock is less dilutive than stock options is very attractive to some employers and is one of the major driving forces in the growing popularity of restricted stock.[4]

Taxation to the employee

The use of restricted stock as a compensation tool results in income recognition for the employee and a deduction for the employer. The timing and amount of the employee's income recognition determines the timing and amount of the employer's deduction. Thus, our discussion of the tax impact of restricted stock starts with the employee's tax treatment. We begin with the basic tax rules, followed by a discussion of several issues that create complexity in applying those rules.

The basics

The taxation of restricted stock is governed by Section 83, which states that the value of property transferred in connection with the performance of services is included in gross income on the earlier of the following:

  • Date on which the property is no longer subject to a substantial risk of forfeiture, or
  • Date on which the property becomes transferable.

With respect to the first event above, restricted stock is no longer subject to a substantial risk of forfeiture when it becomes vested. With respect to the second event, restricted stock is transferable if the employee can transfer the stock to another party on a fully vested basis.[5] In practical terms, it is the vesting of the stock (the first event above) that will be the taxation trigger. It is unlikely that the transferability of the stock (the second event above) would occur first and be the taxation trigger, since that would happen only if the transfer of the stock resulted in the elimination of the vesting requirement. It is hard to imagine an employer's rationale for designing a restricted stock arrangement in this manner. Thus, for purposes of clarity in the remainder of this discussion, we will assume that gross income is recognized on the vesting date.[6]

The income recognized by the employee is compensation income, because the employee receives the restricted stock in return for services. Thus, the income is ordinary income. The amount of income is calculated as follows:

Fair market value of the stock on the vesting date
− Amount the individual is required to pay for the stock (if any)_
Ordinary income

Later, when the employee sells the stock, a capital gain is recognized if the value of the stock has appreciated. If the value of the stock has declined, a capital loss is recognized on the sale. The capital gain holding period, which determines whether the gain or loss is a long-term or short-term gain or loss, begins on the vesting date. Income recognition is illustrated as follows.

Example 1: In year 1, an employee receives 5,000 shares of restricted stock. The employee pays nothing for the stock. The shares vest in year 5. On the vesting date, the FMV is $30 per share. The employee sells the stock in year 8, when the FMV is $40 per share. The employee will report $150,000 of ordinary income when she vests in year 5, calculated by multiplying the FMV per share at the vesting date, $30, by the number of shares, 5,000. When the employee sells the stock in year 8, she will report a capital gain of $50,000, calculated as follows:

Sales price per share

$40

Ordinary income per share previously recognized (i.e., basis in the stock)

- 30

Capital gain per share

$10

Number of shares sold

x 5,000

Total capital gain

$50,000

The gain is a long-term capital gain, because the employee held the stock for more than one year.

Look for part 2 of 4 of this article in the next Buzz or read the entire article in chapter 7.1.2.a: Restricted stock: The Tax Impact On Employers and Employees of the Encyclopedia of Private Equity.


Eddie Adkins is Grant Thornton LLP's Compensation and Benefits Technical Practice Leader, based in the firm's National Tax Office in Washington, D.C. Previously, he spent 17 years at a Big 4 accounting firm, including 12 years as a partner. He has served as COO of a regional pension consulting firm and controller for a privately held company, as well as operated his own CPA firm. He serves on the AICPA Employee Benefits Technical Resource Panel. He received his Master of Accountancy from Virginia Tech.

Jeffrey A. Martin is a manager with the National Tax Office of Grant Thornton LLP located in Washington D.C., specializing in compensation and benefits. Since receiving his Masters in Professional Accountancy from West Virginia University, Jeff has spent the last four years with Grant Thornton practicing both federal taxation as well as compensation and benefits

Grant Thornton LLP is the U.S. member firm of Grant Thornton International, one of the six global accounting, tax and business advisory organizations. Through member firms in more 110 countries, including 50 offices in the United States, the partners and employees of Grant Thornton member firms provide personalized attention and the highest quality service to public and private clients around the globe.

[1] Restricted stock also may be issued to compensate non-employees, such as independent contractors and directors. The tax treatment for non-employees generally is the same as for employees.

[2] APB 25, ô10.

[3] Large public employers were required to adopt SFAS 123(R) in the first quarter of fiscal years beginning after June 15, 2005. Small public employers (annual revenues or market capitalization less than $25 million) were required to adopt in the first quarter of fiscal years beginning after Dec. 15, 2005. Privately held employers were required to adopt in the first fiscal year beginning after Dec. 15, 2005.

[4] Some compensation planners argue that restricted stock is a less effective incentive for employees than stock options, because employees typically make no investment in the stock, and the stock has value to them even if the stock value goes down after the grant date.

[5] Section 83(c)(2).

[6] Reg. 1.83-3(b) states that property, e.g., stock, is "vested" when it is either transferable or not subject to a substantial risk of forfeiture. The term "vested" is commonly used in practice, however, in a manner that means simply that there is no substantial risk of forfeiture.

[7] Reg. 1.83-2(a).

[8] Id. See also Alves, 54 AFTR 2d 84-5281, 734 F2d 478 (CA-9, 1984), aff'g 79 TC 864 (1982).

[9] Reg. 1.83-2(e).

[10] See, e.g., Ltr. Ruls. 8452116 and 8833015.

[11] Section 83(b)(2).

[12] Reg. 1.83-2(f) and Rev. Proc. 2006-31, 2006-27 IRB 13.

[13] Reg. 1.83-3(c)(1).

[14] Reg. 1.83-3(c)(2).

[15] Reg. 1.83-3(c)(1).

[16] Reg. 1.83-3(c)(4), Example 1.

[17] Section 83(c)(3).

[18] Rev. Rul. 2005-28, 2005-19 IRB 997.

[19] Reg. 1.421-1(c)(1).

[20] Reg. 1.409A-1(b)(5)(vi)(B)(1). For more on these rules generally, see Hirsh and Schoonmaker, "Section 409A Final Regs. Provide Comprehensive Guidance for Post-Transition Period," 107 JTAX 150 (September 2007).

[21] Reg. 1.409A-1(b)(5)(vi)(B)(2).

[22] Reg. 1.83-5 contemplates the possibility that a restriction that was intended to be permanent may be cancelled in the future and provides that compensation income will arise as a result of the cancellation.

[23] Reg. 1.83-3(h).

[24] Reg. 1.83-5(a).

[25] Reg. 1.83-3(i).

[26] Section 422(b)(4).

[27] Reg. 1.409A-1(b)(5)(i)(A)(1).

[28] Regs. 1.421-1(e) and 1.409A-1(b)(5)(iv)(B)(1).

[29] Regs. 1.422-2(e)(2)(iii) and 1.421-1(e)(2).

[30] Reg. 20.2031-2.

[31] Reg. 1.422-2(e)(2)(iii).

[32] Reg. 1.409A-1(b)(5)(iv)(B)(1).

[33 ]Reg. 1.409A-1(b)(5)(iv)(B)(2).

[34] Reg. 1.409A-1(b)(5)(iv)(B)(2)(i).

[35] Reg. 1.409A-1(b)(5)(iv)(B)(2)(iii).

[36] Reg. 1.409A-1(b)(5)(iv)(B)(2)(ii).

[37] Reg. 1.83-1(f), Example 1.

[38] Rev. Rul. 83-22, 1983-1 CB 17; Rev. Proc. 83-38, 1983-1 CB 773.

[39] Rev. Rul. 79-305, 1979-2 CB 350.

[40] Reg. 31.3402(g)-1(a) defines supplemental wages to include "wage income recognized on the lapse of a restriction on restricted property transferred from an employer to an employee."

[41] Regs. 31.3402(g)-1(a)(2) and (a)(7)(iii)(F).

[42] Reg. 31.3402(g)-1(a)(2).

[43] Section 3101.

[44] Sections 3301 and 3302.

[45] The income tax liability on $1,000 of income at a 35% rate is $350. The gross-up calculation is as follows: $350 ž [1 ö (1 − .35)].

[46] Reg. 1.83-6(a)(2).

[47] Robinson, 92 AFTR 2d 2003-5349, 335 F3d 1365 (CA-F.C., 2003).

[48] Reg. 1.83-6(d).

[49] Notice 2007-49, 2007-25 IRB 1429. Due to the interaction between the statutory language of Section 162(m) and the recently changed SEC rules, the chief financial officer is not a covered employee.

[50] Section 162(m)(4)(C).

[51] Section 280G(b)(2).

[52] Section 280G(b)(5)(B).

[53] Sections 280G and 4999.

[54] Section 280G(b)(2)(A).

[55] Reg. 1.280G-1, Q&A-22(c) and -24(c)(1).

[56] Id., Q&A-24(c)(4).

[57] Id., Q&A-24(d)(3).

[58] Id., Q&A-12(b).

[59] Id., Q&A-27(a).

[60] Id., Q&A-28(a)(1). There are other circumstances under which a change in control may occur, but restricted stock has no impact on these circumstances.

[61] Rev. Rul. 2005-39, 2005-2 CB 1.

[62] Section 280G(c); Reg. 1.280G-1, Q&A-15 through -19.

[63] Rev. Rul. 2005-39, supra note 61.

[64] Sections 409A(a)(2), (a)(4), and (b).

[65] Section 409A(a)(1).

[66] Reg. 1.409A-1(b)(6).

[67] Reg. 1.409A-1(b)(6)(ii).

[68] Id.

[69] Sections 1361(b)(1)(A) and (D).

[70] Reg. 1.1361-1(b)(3). Stock existing on the effective date of the regulations (tax years beginning after May 27, 1992) that has been treated as outstanding by the corporation, even though it is substantially nonvested, continues to be treated as outstanding for purposes of Subchapter S. A history of issuing a Schedule K-1 with respect to the stock is evidence that the corporation has treated the nonvested stock as outstanding.

[71] Reg. 1.1361-1(l)(1).

[72] Reg. 1.1361-1(b)(3).