Goodbye stock options, hello common stock: companies are returning to the tried-and true grant of common stock.
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.
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, Tim would have $19,000 of taxable compensation income to report in 2007. This is measured by the $20,000 fair market value of the stock minus the $1,000 he paid for the shares.
In its tax year that includes the end of Tim's taxable year 2007, XYZ will have a compensation deduction on its corporate tax return for the same amount ($19,000) that Tim reported as compensation income. [Code Sec. 83(h) and Treas. Reg. 1.83-6(a)].
SELLING TIM'S XYZ STOCK
Tim can only sell his XYZ shares if he continues to work for the company until 2007. For purposes of determining gain or loss upon a sale in 2007 or later, Tim's tax basis is equal to the $1,000 he paid for the stock, plus the $19,000 of compensation income he included on his tax return, or $20,000. [Treas. Reg. Secs. 1.61-2(d)(2) and 1.83-4(b)(1)].
Under the Jobs and Growth Tax Relief Reconciliation Act of 2003, long-term capital gains (i.e., gains from the sale of capital assets held for more than 12 months) are taxed at only 15 percent. Tim's holding period begins Jan. 2, 2007, when the restrictions lapse and the value of the shares is included in his income. [Code Sec. 83(f) and Treas. Reg. Sec. 1.83-4(a)].
Keep in mind, however, that Tim may be forced to sell his shares within 12 months simply to pay the income tax on the compensation income he has to report on his tax return. If so, Tim will have short-term capital gain or loss.
What if prior to the lapse of the restrictions, XYZ pays a dividend on its common stock? Since Tim's shares are forfeitable, he is not treated as the "owner" of the stock. Rather, XYZ is considered the owner for tax purposes and any income generated by the restricted property is treated as additional compensation paid by XYZ to Tim. [Treas. Reg. Sec. 1.83-1(a)(1)].
Under the 2003 Tax Act, dividends received after Dec. 31, 2002 and before Jan. 1, 2009, are subject to a maximum rate of 15 percent, the same tax rate applicable to long-term capital gains.
Unlike the restricted XYZ shares, Tim may not defer or postpone including the dividend income on his tax return until the restrictions lapse. Since Tim did not receive the dividend payment as the owner of the shares, the payment amount will be taxable as ordinary income and will not be eligible for the lower 15 percent tax rate on ordinary dividends under the 2003 Tax Act.
On the employer's side, XYZ would have a corresponding deduction for the additional compensation paid to Tim as an employee.
While this deduction has the odd appearance of allowing a corporation to deduct its own dividend payment, this result is consistent with the treatment of XYZ--not Tim--as the owner of the restricted stock.
Once Tim vests in the XYZ shares on Jan. 2, 2007, he is considered the owner of the shares and any subsequent dividends paid by the company would be subject to a maximum tax rate of 15 percent in Tim's hands.
SECTION 83(B) ELECTION TO RECOGNIZE INCOME
"Accelerate deductions and postpone income" is the CPA's tax year-end mantra. However, employees might enhance their tax position by voluntarily including in their income the value of restricted stock earlier than required under the general rule. This can be done by the use of a Sec. 83(b) election.
As discussed above, the value of property transferred subject to restrictions (such as restricted stock) is normally taxable at the time the restrictions lapse. However, under Sec. 83(b), employees may elect to immediately include the value of the restricted stock in taxable income at the time the stock is transferred to them, even though the stock remains forfeitable.
By doing so, the employee becomes the owner of the stock so that the long-term capital gains holding period begins to run. [Code Sec. 83(b) and Treas. Reg. Sec. 1.83-2(a)].
However, a Sec. 83(b) election does not cancel the contractual restrictions and the employees may still forfeit the shares if they fail to satisfy the restrictions on the stock.
Why would employees make these elections on their tax return earlier than required--and risk the wrath of the CPA? The answer is that a Sec. 83(b) election makes sense only if there is little, if any, income to include on the employee's tax return relative to the expected future increase in the stock's value.
By accelerating the taxability of a small amount of compensation immediately upon receiving the restricted stock, employees are betting that the stock price will increase and the sooner their 12-month holding period starts, the sooner they will be able to sell the stock at the favorable long-term capital gains rate.
TIM'S SECTION 83(B) ELECTION
Using the above example, if Tim made a Sec. 83(b) election, he will recognize $3 per share of compensation income immediately upon receiving his XYZ restricted stock Jan. 2, 2003. This is equal to its $4 fair market value less the $1 he paid for it. Since he included the value of the shares in income, Tim's holding period begins on the same date. [Treas. Reg. Sec. 1.83-4(a)].
His tax basis is equal to the $3 of taxable income, plus $1 purchase price, or $4 per share. Instead of postponing the taxability of the restricted stock, Tim has elected to convert any future appreciation in the XYZ shares into income taxed at the lower capital gain rates if and when he chooses to sell the stock.
Without a Sec. 83(b) election, any appreciation during the time the shares are subject to restrictions will be taxable as ordinary compensation income when the restrictions lapse. [Treas. Reg. Sec. 1.83-1(a)].
With a Sec. 83(b) election, even if he does not sell, Tim has deferred indefinitely the recognition of any additional income. In other words, he will have no additional income to include when the restrictions lapse and the shares vest.
In addition, any dividends paid on the XYZ shares during the period the restrictions are in place will be taxed at the lower 15 percent tax rate on regular dividends, and not additional compensation income because Tim is considered the owner of the shares for tax purposes.
Remember that making a Sec. 83(b) election will not allow Tim to immediately sell his XYZ shares because they remain restricted. However, when the restrictions lapse in January 2007, Tim can sell the shares and recognize a long-term capital gain of $16 per share subject to the new tax rate of 15 percent.
And therein is the downside to the Sec. 83(b) election: waiting for the restrictions to lapse.
In the above example, if the price of XYZ shares goes down and never recovers, Tim will have recognized compensation income, but the corresponding economic value has since vanished. If Tim sells the stock at $2 per share after the restrictions lapse, he will realize a $2 per share long-term capital loss. Such losses can be offset against capital gains, but only $3,000 can be deducted against ordinary income. The remainder can be carried forward to future tax years.
If Tim were to leave XYZ prematurely and forfeit his stock after making the election, the tax consequences are more severe. XYZ would return to Tim the $1 per share he paid for the stock and he could not deduct the additional $3 per share of compensation income. [Code Sec. 83(b)(1)].
Why? Under the structure of Sec. 83, Tim can avoid the economic loss of $3 per share by waiting until the restrictions lapse and then including the value of the restricted stock on his tax return. However, if he chooses (or gambles) by making a Sec. 83(b) election and accelerating the taxability of the stock, he is faced with the possibility of a later forfeiture without a corresponding tax deduction for his loss.
Even with this potential downside, a Sec. 83(b) election should always be considered upon the receipt of restricted stock.
The window for making an election is a short 30 days from the date of the receipt. If the spread between the purchase price and the fair market value of the property at the time of receipt is fairly small, a Sec. 83(b) election may be a good strategy to start the long-term capital gain clock running and to increase the amount of future appreciation subject to the new 15 percent rate under the 2003 Tax Act.
Boyd D. Hudson is a certified tax law specialist with Adams, Hawekotte & Hudson in Pasadena. Robert A. Yahiro is business and tax lawyer with Rodi, Pollock, Pettker, Galbraith & Cahill in Los Angeles. You can reach them at email@example.com and firstname.lastname@example.org, respectively.
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|Author:||Yahiro, Robert A.|
|Date:||Jan 1, 2004|
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