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Restricted stock awards and taxes: What employees and employers should know

Forfeiture risk, stock's potential future value are key considerations for Sec. 83(b) elections.

By Steven T. Petra, CPA, Ph.D. and Nina T. Dorata, CPA, Ph.D.
February 2012
Section 83

The use of restricted stock awards to compensate employees is growing in popularity in place of the much-maligned stock option. One of the reasons for the shift to restricted stock is the reduced charge against income provided by restricted stock awards as compared to stock option grants. Restricted stock is also less dilutive to the company’s stock than options, because value to the employee can be achieved with fewer shares.

Executive compensation practices came under increased congressional scrutiny when abuses at corporations such as Enron became public. The American Jobs Creation Act of 2004, P.L. 108-357, added Sec. 409A, which accelerates income to employees who participate in certain nonqualified deferred compensation plans (including stock option plans). Later in 2004, FASB issued Statement no. 123(R), Share-Based Payment, which requires expense treatment for stock options for annual periods beginning in 2005. (Statement no. 123(R) is now incorporated in FASB Accounting Standards Codification Topic 718, Compensation—Stock Compensation.) The median number of stock options (per company) granted by Fortune 1000 firms declined by 40% between 2003 and 2005, and the median number of restricted stock awards increased by nearly 41% over the same period (“Expensing Rule Drives Stock Awards,” Compliance Week, March 27, 2007). From 2004 through 2010, the number of restricted stock holdings of all reporting executives in the S&P 500 increased by 88%.

 

With the increased popularity of restricted stock, CPA tax practitioners must be familiar with the rules governing taxation of restricted stock awards when advising clients who have been or may be offered restricted stock awards, as well as when advising corporations that make the awards.

 

RISK OF FORFEITURE AND NONTRANSFERABILITY

Sec. 83 determines the income tax consequences to both the award’s receiver (the employee) and its grantor (the employer). Under Sec. 83(a), property transferred to an employee as compensation for services is taxable to the employee on the earlier of the date the property is not subject to a substantial risk of forfeiture by the employee or the date it is transferable by the employee.

 

Under Regs. Sec. 1.83-3(c)(1), a substantial risk of forfeiture exists where rights in the stock are conditioned, directly or indirectly, upon the future performance (or refraining from performance) of substantial services by the employee (commonly referred to as an “earn-out” restriction), or the occurrence of a condition related to a purpose of the transfer, and the possibility of forfeiture is substantial if such condition is not satisfied. An example of a condition related to the purpose of a transfer is a requirement that the employee return the stock if the total earnings of the company do not increase. One of the more common requirements is that the employee remain with the company for a certain time. However, Regs. Sec. 1.83-3(c)(2) indicates that a requirement that the stock be returned upon the employee’s being discharged for cause or for committing a crime will not be considered a substantial risk of forfeiture. An enforceable requirement that the employee agree to a covenant not to compete after leaving the company’s employ or the employee’s agreeing to provide consulting services after retirement will also not be considered a substantial risk of forfeiture unless the particular facts and circumstances indicate otherwise.

 

Regs. Sec. 1.83-3(c)(3) warns that a substantial risk of forfeiture will not exist where employees own a substantial amount of the voting stock or other classes of company stock, unless they can demonstrate that they do not control the company and the possibility of the company’s enforcing the forfeiture restriction is substantial. Also, stock is not subject to a substantial risk of forfeiture to the extent that the employer is required to pay the fair market value (FMV) of the stock to the employee upon the return of the stock (Regs. Sec. 1.83-3(c)(1)).

 

Under Regs. Sec. 1.83-3(d), the stock is nontransferable if the employee is prohibited from selling, assigning or pledging (as collateral for a loan, as security for the performance of an obligation or for any other purpose) his or her interest in the stock to any person. Additionally, the stock will be considered nontransferable if the transferee is subject to the forfeiture restrictions, even if the employee is permitted to sell, assign or pledge the stock. An example in Regs. Sec. 1.83-1(f) provides a safe harbor for the employee: If evidence of the risk of forfeiture is stamped on each stock certificate, the stock is considered nontransferable. The regulations also provide that the stock will not be considered transferable merely because the employee may designate a beneficiary to receive the stock at death.

 

Consequently, a restricted stock award will result in taxable income to the employee under Sec. 83 in an amount equal to the excess of the stock’s FMV on the date the restriction lapses, over the stock’s sale price to the employee. The employee adjusts his or her original basis in the stock by the income amount. The employer may claim a deduction on the date the restriction lapses for the amount included in the employee’s income.

 

In situations where the employee purchases the employer’s stock with monies borrowed from the employer, Regs. Sec. 1.83-4(c) requires the employee to include in income any amount that is subsequently canceled, forgiven or satisfied for an amount less than the indebtedness, in the tax year in which the cancellation, forgiveness or satisfaction occurs. Sec. 83(h) allows a deduction to the employer in a similar amount.

 

ELECTION TO ACCELERATE INCOME INCLUSION

Sec. 83(b) allows the employee to accelerate the recognition of income by electing to include the compensation portion of the restricted stock (any excess of its FMV at the time of the transfer over the amount paid for it, determined without regard to any restriction other than a permanent restriction on its transferability) in gross income in the year the award is received. The lapse of the restrictions is not a taxable event if the employee makes the election. The election can be beneficial to the employee, as any appreciation in stock value between the date of the award and the date the restrictions lapse is taxed only if and when the employee disposes of the stock. Additionally, the employee’s holding period starts on the award date, not when the restrictions lapse, so when the employee disposes of the stock, the appreciation is taxed not at the ordinary income tax rate but rather at the lower, long-term capital gain tax rate (assuming it has been held for more than one year). Therefore, in situations where the employee expects the stock price to increase during the restricted period, he or she can expect to reduce tax liability by the spread between his or her ordinary tax rate and the long-term capital gain tax rate. However, the election can be detrimental where the stock later declines in value or is forfeited. See “Risks for the employee” below.

 

Regs. Sec. 1.83-2(a) allows the election in situations where the employee has paid full value for the stock, realizing no bargain element in the transaction. In such cases the employee will recognize no income on the date of the award and will avoid compensation income for appreciation in the stock after the award.

 

The Sec. 83(b) election may take on additional significance for directors, officers and principal stockholders of the employer who are subject to “short swing” trading profit liability under Section 16(b) of the Securities Exchange Act of 1934. Sec. 83(c)(3) provides that this potential liability is a restriction as defined in Sec. 83(a). Therefore, the compensatory sale of stock to those covered by the Section 16(b) liability could result in unanticipated compensation income to the purchaser even where the stock appears to be unrestricted (that is, there are no substantial risk of forfeiture or nontransferability restrictions) in all other aspects. Making the Sec. 83(b) election allows the individual to avoid compensation income when the Section 16(b) restriction lapses.

 

Method of making the election. Sec. 83(b)(2) stipulates that the Sec. 83(b) election must be made no later than 30 days from the date of the transfer. Regs. Sec. 1.83-2 requires the employee to file the election in the form of a written statement with the IRS office at which the employee regularly files his or her tax returns and attach a copy to the return. The employee must send a copy of the election to the employer; if the transferee of the property is not the employee, the employee must provide a copy of the election to the transferee. The statement’s required information is specified in Regs. Sec. 1.83-2(e).

 

Revocability. Sec. 83(b)(2) also stipulates that the election is irrevocable without the IRS’ consent. However, Rev. Proc. 2006-31 permits a revocation if the employee files it on or before the due date for making the election. Additionally, under Regs. Sec. 1.83-2(f), revocation will be granted where the transferee is under a mistake of fact as to the underlying transaction and the revocation is requested within 60 days of the date on which the mistake of fact first became known to the person who made the election. Section 5, Example 3 of Rev. Proc. 2006-31 describes as an example of a mistake of fact a situation where a different class of stock is transferred to an employee than the class specified under an employment contract, where after making the election, the employee discovers the transferred stock is of a different class. However, a mistake about the value of the property with respect to which the employee made the election, or a failure to perform an act contemplated at the time of transfer of the property does not constitute a mistake of fact. A mistake of fact does not include a mistake of interpretation of law, including misunderstanding the forfeiture rules or any other aspect of the proper tax treatment of the transfer.

 

Risks for the employee. The election under Sec. 83(b) carries at least two risks to the employee. One is that the property may not in fact appreciate but, rather, depreciate during the restricted period. In such case, the amount included in income when the employee made the election is not now deductible. Also, the employee can take a loss deduction only when he or she sells the stock, and the deduction will be subject to capital loss limitation rules. Employees will find themselves in the unenviable position of having reported ordinary income at the time of the award and paid the requisite income tax, followed by a capital loss upon its later disposition. Thus, if the employee is uncertain as to the growth or decline in value of the stock received, he or she might consider not making a Sec. 83(b) election.

 

A second risk is that, under Sec. 83(b)(1), no deduction is allowed to the employee if the stock is forfeited. Remember, as discussed earlier, a misunderstanding of the forfeiture provisions is not justification for revoking the election. However, Regs. Sec. 1.83-2(a) does permit a capital loss deduction for the excess paid for forfeited stock above any amount realized upon the forfeiture, including any amount of the purchase price restored by the employer to the employee.

 

Regs. Sec. 1.83-2(a) also warns that a sale or other disposition of the property that is in substance a forfeiture or is made in contemplation of a forfeiture shall be treated as a forfeiture.

 

The risk of forfeiture was brought painfully to light in Kadillak (127 T.C. 184 (2006), aff’d, 534 F.3d 1197 (9th Cir. 2008)). By exercising incentive stock options granted to him by his employer, Anthony Kadillak purchased company stock that was subject to the restriction that the company could exercise the right to repurchase the stock if his employment with the company terminated within four years of the award. The company held the shares in escrow and would transfer them to Kadillak as they vested over the four-year period. Kadillak timely filed a Sec. 83(b) election for the shares. On his tax return for the year of the award, Kadillak reported alternative minimum taxable income (AMTI) of more than $4 million, of which approximately $3.26 million represented the difference between the value of the stock and its cost to him. About one year after the award, Kadillak’s employment with the company was terminated, and the company repurchased his nonvested shares at cost. Kadillak then filed an amended return for the year of the award, claiming that AMTI should not be recognized on the nonvested shares.

 

Before the Tax Court, Kadillak argued the Sec. 83(b) election was invalid because the company held the shares in escrow and they were not legally transferred to him. The court, however, reasoned that, because Kadillak held all shareholder rights in the nonvested stock, including rights to dividends, he held the stock as the beneficial owner; therefore, his Sec. 83(b) election was valid, and he owed tax on the full $3.26 million AMTI, as reported on his original return. Kadillak appealed to the Ninth Circuit, which affirmed the Tax Court’s holding.

 

Corporate deductibility. The Sec. 83(b) election also affects the amount and timing of the deduction permitted the corporation on its income tax return. Generally, corporations granting restricted stock awards to employees are permitted a tax deduction when the restrictions lapse. However, where the employee has made a Sec. 83(b) election, the corporation’s deduction is accelerated to the award date. In situations where the stock price has increased during the restriction period, the Sec. 83(b) election results in a lower deduction for the corporation than if the Sec. 83(b) election had not been made.

 

Restricted stock units. Some employers choose to issue restricted stock units (RSUs) to employees rather than restricted stock, because employees cannot make a Sec. 83(b) election in connection with restricted stock units. RSUs are unfunded promises to pay cash or stock to the employee based on a vesting schedule. One RSU is typically equal in value to one share of company stock. The company does not deliver the cash or shares of stock until the vesting and forfeiture requirements have been satisfied. RSU participants have no voting rights on the stock during the vesting period, because they actually have not been issued any stock. The rules of each plan determine whether RSU holders receive dividend equivalents. Issuing RSUs allows the employer (rather than the employee) to control the timing of the compensation deduction and to have the possibility of a larger deduction should the value of the employer’s stock increase during the restricted period. Additionally, employers who issue RSUs do not need to keep track of whether employees have made the Sec. 83(b) election.

 

HELPING CLIENTS MAKE AN INFORMED DECISION

It is imperative that employees understand the tax consequences under Secs. 83(a) and (b) so they can make an informed decision and not get stuck with an unexpected tax liability. CPA tax practitioners should advise their clients who have been or may be offered restricted shares of the benefits and risks associated with a Sec. 83(b) election. The election will be beneficial to the client if the client is confident that he or she will not forfeit the stock and that the stock will appreciate in value during the restricted period. On the other hand, the election will not benefit the client if he or she forfeits the stock and/or the stock declines in value after the election is made.

 

CPA tax practitioners advising corporate clients issuing restricted stock should point out that the amount and timing of the compensation deduction on the corporate tax return for restricted stock can be affected by the employees’ actions. The deduction could be reduced if employees are permitted to make the Sec. 83(b) election. Such a possibility does not exist, however, if the corporation issues restricted stock units rather than restricted stock.

 

 


 

EXECUTIVE SUMMARY

 

 While compensatory stock options have fallen out of favor, use of restricted stock awards has increased. The stock is not taxable to the employee until either it is no longer subject to a substantial risk of forfeiture by the employee or is transferrable by the employee.

 

 A risk of forfeiture generally exists if the employee must remain employed by the company, or the company’s earnings hit specified targets and the employer is not obligated to pay the stock’s fair market value (FMV) to the employee if it is forfeited.

 

 Employees may elect instead under Sec. 83(b) to include in gross income at the time of transfer the stock’s FMV (without regard to any restriction other than a permanent restriction on its transferability) above the amount they paid for the stock. However, risks for employees include that no deduction for a loss on disposition of the stock is generally allowed if the stock is forfeited. The election may be revoked only under a few circumstances including a “mistake of fact” concerning the election.

 

 CPAs can help individual taxpayer clients make informed decisions concerning restricted stock and whether they should make a Sec. 83(b) election. Those who advise corporate clients can provide guidance concerning the amount and timing of a deduction for restricted stock compensation paid.

 

Steven T. Petra (actstp@hofstra.edu) is a professor and director of graduate programs in taxation at Hofstra University in Hempstead, N.Y. Nina T. Dorata (doratan@stjohns.edu) is an associate professor at St. John’s University in New York City.

 

To comment on this article or to suggest an idea for another article, contact Paul Bonner, senior editor, at pbonner@aicpa.org or 919-402-4434.

 


 

AICPA RESOURCES

 

JofA article

When a client leaves or loses a job,” Feb. 2012, page 40

 

The Tax Adviser articles

  • “Tax Implications of Transactions Involving Contingent Consideration,” Aug. 2010, page 558
  • “Tax Clinic: Sec. 83 in the Context of Contract Manufacturing,” Sept. 2009, page 590
  • “Tax Clinic: Restricted Stock in Acquisitions: IRS Provides Much-Needed Guidance,” April 2008, page 199

 

To find articles from The Tax Adviser, go to thetaxadviser.com and search by year in the left-hand column.

 

CPE self-study

  • AICPA’s 1040 Tax Return Workshop by Sid Kess (#735226)
  • AICPA’s 2011 Individual Tax Review Series: Beyond the Basics (#733634)
  • Innovative Tax Planning for Individuals and Sole Proprietors (#745535)

 

Conference

Conference on Employee Benefit Plans, April 30–May 2, Atlanta

 

For more information or to make a purchase or register, go to cpa2biz.com or call the Institute at 888-777-7077.

 

The Tax Adviser and Tax Section

The Tax Adviser is available at a reduced subscription price to members of the Tax Section, which provides tools, technologies and peer interaction to CPAs with tax practices. More than 23,000 CPAs are Tax Section members. The Section keeps members up to date on tax legislative and regulatory developments. Visit the Tax Center at aicpa.org/tax. The current issue of The Tax Adviser is available at thetaxadviser.com.


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