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# Restricted stock: The Tax Impact On Employers and Employees - Part 2 of 4

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

Section 83(b) election

An employee can report the gross income associated with restricted stock in the year the stock is granted (i.e., transferred), rather than waiting until the year in which the stock vests. This Section 83(b) election is available for restricted stock but not for restricted stock units, because typically the stock is not transferred until it vests.

When a Section 83(b) election is made, the income that is recognized is based on the stock's FMV on the grant date, rather than the FMV on the vesting date. The gross income recognized in connection with a Section 83(b) election is ordinary income. There is no further income recognition until the stock is sold, when a capital gain or loss is recognized. For purposes of determining whether the capital gain is a short-term or long-term gain, the holding period begins on the date the stock is transferred, rather than the vesting date.

Example 2: The facts are the same as in Example 1 above. The FMV of the stock on the date of grant in year 1 is \$10 per share. The employee makes a Section 83(b) election to recognize income on the grant of the restricted stock. As a result, the employee will report \$50,000 of ordinary income in year 1, calculated by multiplying the \$10 FMV per share at grant date by the number of shares, 5,000. When the employee vests in the stock in year 5, there is no income recognition, due to the fact that the employee chose to recognize income in year 1.

When the employee sells the stock in year 8, she will report a capital gain of \$150,000, calculated as follows:

 Sales price per share \$40 Ordinary income per share previously recognized (i.e., basis in the stock) - 10 Capital gain per share \$30 Number of shares sold x 5,000 Total capital gain \$150,000

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

Exhibit 1 summarizes the income recognition from the two examples above (i.e., with and without a Section 83(b) election). Under both scenarios, the total income recognized is \$200,000. The two scenarios vary significantly, however, in the composition of the income. When the employee makes a Section 83(b) election, a large portion of the appreciation in the stock's value is taxed at the more favorable capital gains rate of 15%. In contrast, if the employee does not make a Section 83(b) election, most of the gain is taxed at the ordinary income tax rate (a rate as high as 35%).

 Exhibit 1 Impact of the 83(b) election in Examples 1 and 2 No section 83(b) election With section 83(b) election Ordinary income \$150,000 \$ 50,000 Capital gain 50,000 150,000

While a Section 83(b) election may minimize the total income tax liability, the decision to make the election should not be taken lightly. In Example 2, the employee reports \$50,000 of ordinary income in year 1, even though the stock does not vest until year 5. Suppose the employee leaves the employer in year 3 and, as a result, she does not become vested in the stock. The law does not permit the employee to recover the income taxes she paid in year 1. She has paid taxes on \$50,000 of income that she never actually received. This is one of the risks associated with a Section 83(b) election. Another risk is the possibility that the stock will decline in value, causing the employee to recognize a higher amount of ordinary income than she would have without a Section 83(b) election.

Restricted stock plans are sometimes designed so that the employee is required to pay some amount for the stock. When an employee makes a Section 83(b) election and later forfeits the stock, a capital loss is recognized equal to the amount paid for the stock (but only if the employer does not refund the purchase price to the employee).[7] In Example 2, if the employer had required the employee to pay \$1 per share for the stock in year 1, for a total of \$5,000, she would report a capital loss of \$5,000 on her income tax return for year 3 when she forfeited the stock.

The discussion above highlights the considerable risks associated with a Section 83(b) election. When the stock has little or no value on the grant date, however, little or no income will be reported as a result of the election, resulting in little to no risk in making the election. Also, if the employee is required to pay a significant amount for the restricted stock, the income reported as a result of the election may be relatively small. For example, if the employee is required to pay the full FMV for the stock, the income reported in connection with the Section 83(b) election would be zero. The regulations specifically allow the election to be made, even when the employee has paid the full value for the stock.[8]

As an employee considers whether to make a Section 83(b) election, she should take into account the various advantages and disadvantages of the election. The major advantages and disadvantages are summarized in Exhibit 2.

 Exhibit 2 Section 83(b) elections: major advantages and disadvantages Advantages Disadvantages If the stock increases, more of the appreciation is capital gain rather than ordinary income Accelerates the payment of taxes (an issue particularly if the stock has high value on the transfer date) Capital gain holding period begins at grant date rather than at vesting date If the stock value decreases between the grant date and vesting date, the election results in a larger amount of ordinary income than would have been the case without the election If the stock is forfeited, there is no loss deduction (except for the amount, if any, paid by the employee for the stock and not refunded by the employer)

Reg. 1.83-2 sets forth certain procedures that must be followed and information that must be supplied to make a valid Section 83(b) election; there is no IRS form for this purpose. The information includes the date the stock is transferred, the nature of the restrictions on the stock and the FMV of the stock on the transfer date.[9] The procedures for filing the election include the following:

• The election must be filed with the IRS office where the individual files the 1040 return;
• The deadline for filing the election with the IRS is 30 days after the stock's transfer;
• A copy of the election must be given to the employer; and
• The election must be attached to the individual's income tax return for the year in which the election is made.

The most important of these is the requirement to file the election with the IRS within the 30-day deadline. If this deadline is missed, an election cannot be made. The other requirements are less important, and a valid election will probably exist even if these requirements are not met. For example, the IRS has held that an election is valid even though the employee fails to attach it to the tax return.[10]

Given the risks associated with a Section 83(b) election, a common question is whether the election can be revoked. An election cannot be revoked without the IRS's approval.[11] The IRS has issued specific guidance and procedures for seeking a revocation.[12] If the employee seeks the revocation within the first 30 days after the stock is granted, the revocation will be approved. After that, the IRS will approve a revocation only when the employee made the election under a "mistake of fact," which is "an unconscious ignorance of a fact that is material to the transaction." A Section 83(b) election that is properly revoked is given no effect.

The failure of the employee to understand the substantial risk of forfeiture associated with the restricted stock is not a mistake of fact. In addition, the failure of the employee to understand the tax consequences of making the Section 83(b) election is not a mistake of fact. A mistake as to the value of the stock also is not considered a mistake of fact. Even when there has been a mistake of fact, the IRS will not approve a revocation unless the request is made within 60 days of the date on which the mistake of fact first became known to the employee.

In addition to a proper revocation, a Section 83(b) election may be given no effect when the restricted stock transaction is rescinded. In Ltr. Rul. 9104039, the IRS held that a Section 83(b) election would be ignored when the employer rescinded its transfer of restricted stock to the employees. In this ruling, the rescission action was taken in the same tax year as the grant, and the IRS made it clear that this was an important fact in reaching its conclusion.

Substantial risk of forfeiture

As discussed above, the value of restricted stock is included in the employee's income when it is no longer subject to a substantial risk of forfeiture (unless a Section 83(b) election is made). Thus, it is important to determine when a substantial risk of forfeiture lapses so that income is reported at the proper time.

Section 83(c)(1) provides that "substantial risk of forfeiture" means the "future performance of substantial services." In addition, a substantial risk of forfeiture exists when vesting is contingent on the "occurrence of a condition related to the purpose of the transfer.[13]

In the past, employers commonly used relatively simple vesting conditions, based only on continued employment. For example, an employee would vest in restricted stock if she remained with the employer for three years beyond the grant date. Currently, there is a growing interest in vesting conditions that involve conditions beyond that of mere continued employment. An example of this is restricted stock that becomes vested if the employer's revenues increase by 10% each year for the next two years.

These conditions are commonly referred to as "performance" conditions, and can qualify as a valid substantial risk of forfeiture because they are a "condition related to the purpose of the transfer," as mentioned above. Additional examples of performance-based vesting conditions include the following:

These types of vesting conditions give employees an incentive to perform at a high level in addition to simply remaining with the employer. The accounting rules under APB 25 made performance conditions undesirable, because the compensation cost had to be adjusted each reporting period based on the current value of the stock (variable accounting, which generally is viewed as undesirable due to the potential volatility in cost). Under SFAS 123(R), performance conditions no longer result in variable accounting. Consequently, performance vesting conditions are increasing in popularity.

Another vesting condition that is sometimes used involves a noncompetition requirement (e.g., stock must be returned to the employer if the employee accepts a job with a competing firm). This type of condition ordinarily will not be treated as a substantial risk of forfeiture for Section 83 purposes. Factors that may be taken into account in determining whether a covenant not to compete constitutes a substantial risk of forfeiture are the age of the employee, the availability of alternative employment opportunities, the likelihood of the employee's obtaining other employment, the degree of skill possessed by the employee, the employee's health and the practice of the employer to enforce noncompete covenants.[14]

The regulations address yet another situation in which a substantial risk of forfeiture may exist. Specifically, Reg. 1.83-3(c)(1) states that "[p]roperty is not transferred subject to a substantial risk of forfeiture to the extent that the employer is required to pay the fair market value of a portion of such property to the employee upon the return of such property." This statement implies that the converse would be true, that is, stock is subject to a substantial risk of forfeiture if the employer is required to pay a value other than the FMV (presumably, a lower value) to the employee on the return of the stock to the employer. Rev. Rul. 2007-49, 2007-31 IRB 237, sheds light on this concept by providing examples where an employee who terminates his employment within a specified period of years must sell the shares back to the employer at the lesser of a stated amount or the FMV at the time the employment is terminated. In these examples, the IRS treats the stock as subject to a substantial risk of forfeiture. Reg. 1.83-3(c)(1), however, specifically provides that a nonlapse restriction (a permanent requirement to sell the stock to the employer at a formula value, as discussed later in connection with the determination of FMV) is not a substantial risk of forfeiture.

Regardless of the specific vesting conditions chosen, the conditions must be "substantial." A risk of forfeiture that is not substantial will be disregarded, and the employee must include the value of the restricted stock in gross income on grant. The determination of whether a risk of forfeiture is substantial is based on all of the surrounding facts and circumstances.[15]

One common question relates to how long the vesting period must be in order for the risk of forfeiture to be substantial. There is no clear answer to this. The regulations include an example, however, in which two years is treated as a substantial risk of forfeiture.[16] Thus, some tax practitioners take the position that a two-year vesting period is adequate to create a substantial risk of forfeiture, and that any period less than two years is somewhat risky (i.e., it may be treated by the IRS as insubstantial, resulting in immediate taxation on the grant of the stock).

Special care must be taken in determining whether there is a substantial risk of forfeiture on the part of an employee who owns a significant amount of the total combined voting power or value of all classes of stock of the employer. The concern is that the employee may have so much influence and authority that she can waive her risk of forfeiture, resulting in an insubstantial risk of forfeiture.

Reg. 1.83-3(c)(3) provides general guidelines for this situation, including two examples. The guidelines focus on the employee's relationship with (and degree of control over) the other shareholders, the employee's relationship with officers and directors, and the employee's role in the company. The corporation's prior history in enforcing vesting requirements is also taken into account. In the first example, the employee owns 20% of the employer's stock, with the remaining 80% owned by unrelated individuals. In this example, the regulations conclude there is a substantial risk of forfeiture because the possibility of the corporation enforcing a restriction is substantial. In the second example, however, the employee (the company president) holds 4% of the voting power of all of the employer's stock, with the remaining stock held "diversely" by the public. In this example, there is not a substantial risk of forfeiture because the president effectively controls the corporation.

A special rule under Section 83 relates to section 16(b) of the Securities Exchange Act of 1934. That Act restricts the sale of stock at a profit within six months after the purchase of the stock. Under the special rule, the stock is treated as both subject to a substantial risk of forfeiture and not transferable during this six-month period. Thus, there is no taxable event until the section 16(b) restriction period ends.[17] Restrictions on transferability that apply under any other securities laws are not accorded this same treatment; thus, stock that otherwise is vested is subject to tax, despite these restrictions.[18] Similarly, stock issued by a private company that is subject to restrictions on its transferability is taxed on vesting, despite the restrictions.

Look for part 3 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 than 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  [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).