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
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 non-qualified 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. [ILLUSTRATION OMITTED] 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. 1.833(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 (Pegs. …