Restricted stock awards are a popular replacement for stock option grants.
The reason is that the awards typically retain their value if the price of the stock drops. The company simply needs to award additional restricted shares. Stock options on the other hand lose most or all of their value if the underlying stock goes down in price.
However, there are federal income and employment tax implications for restricted stock awards.
Restricted Stock Basics
In a typical restricted stock arrangement, an executive receives company stock subject to one or more restrictions. The most common restriction is a requirement for continued employment through a designated date. Often, the stock is transferred at no or minimal cost. The right to keep the shares is forfeited if the executive fails to fulfill the terms.
Tax-wise, the executive’s recognition of taxable income and the employer’s right to claim the related compensation deduction are both generally deferred until vesting, or when ownership of the shares is no longer restricted.
Timing of Income Recognition
When the restricted stock is received, the recipient recognizes income for federal tax purposes in one of two ways:
1. Without Section 83(b) Election: The restricted stock award results in the recognition of ordinary compensation income in the year the restriction causing the substantial risk of forfeiture lapses. The amount included in compensation income is the excess of the stock’s value when the restriction lapses over any amount paid for the stock. Federal income tax and federal employment taxes must be paid on the amount treated as compensation.
2. With Section 83(b) Election: A recipient can make a Section 83(b) election to recognize income on the date the restricted shares are received. This accelerates the tax effects for both the executive and the employer.
The election results in the immediate recognition of ordinary compensation income equal to the excess of the stock’s value over any amount paid for the stock. Federal income tax and federal employment taxes must be paid on the amount treated as compensation. The election must be made either before the share transfer or within 30 days after the share transfer.
Weighing Tax Deferral vs. Preferential Long-term Capital Gain Treatment
When no Section 83(b) election is made, the stock’s value less any amount paid for it is recognized as taxable compensation for income and employment tax purposes when the stock becomes fully vested. Any stock appreciation between the date of the award and the date of the vesting is treated as high-taxed ordinary income from compensation.
Alternatively, the executive can make a Section 83(b) election to be taxed when the stock is awarded. In that case, the executive is taxed on the stock’s value when it is awarded minus any amount paid for the stock.
Any subsequent appreciation is treated as capital gain, which will qualify for preferential tax rates if the stock is held for more than one year. The tax rates will be much lower than the maximum rate on ordinary income from compensation. The downside is that the executive must recognize taxable income at the time of the restricted stock award even though the restricted stock may later be forfeited or decline in value.
Requirements for Restricted Stock Treatment
For federal income and employment tax purposes, stock is considered to be restricted (meaning not vested) when both of the following conditions are met.
1. Subject to a Substantial Risk of Forfeiture: This condition is met if full ownership of the stock depends on the future performance, or refraining from the performance, of substantial services by the recipient executive.
2. Not Transferable: This condition is met if the recipient transfers any interest in the stock to any person or entity other than the employer. The new holder’s rights to the stock are still subject to the same substantial risk of forfeiture.
For instance, stock meets the not-transferable requirement if the recipient can sell it, but the new holder must still forfeit the stock upon the occurrence of the event causing the substantial risk of forfeiture. That typically is premature termination of the executive’s employment. To ensure that any subsequent holder is aware of the restriction(s) and the non-transferable requirement is met, the shares are commonly stamped with a legend that discloses that information.
Substantial Risk of Forfeiture
Stock is subject to a substantial risk of forfeiture if the rights to full ownership depend (directly or indirectly) on either.
- The future performance of substantial services by the recipient, or
- The satisfaction of a condition related to the award. For example, the recipient may be required to obtain an advanced educational degree, or a specified professional designation, or attain a certain job status within the company for the restricted stock to become vested.
Example: Your employer transfers 10,000 shares to you. You pay nothing for the stock, which is valued at $20 per share on the date of the transfer. Under the terms of the deal, you must forfeit the shares back to your employer if you leave the company for any reason before three years after the date of the transfer.
If you sell the shares, whoever buys them must also forfeit them if you leave the company before the magic date. Since you must perform substantial services over the next three years to gain full ownership of the stock, the shares are considered subject to a substantial risk of forfeiture. As a result, the shares are considered restricted stock and are subject to the income and withholding tax considerations.
Employer’s Compensation Deduction
Assuming the income related to the transfer of restricted stock is properly reported to the recipient on forms W-2 or 1099, the employer is allowed to claim a compensation deduction equal to the amount included in the executive’s income.
The tax rules for restricted stock are fairly straightforward. The major tax planning consideration for the executive is deciding whether or not to make a Section 83(b) election.
In many cases, the risks of making the election will be perceived as greater than the potential tax-saving benefit, but you should consult your tax advisor before making that call.