Tax aspects of restricted stock and stock options. (The 2002 Law Journal).

Equity-based compensation is often used to attract, retain and motivate key employees in lieu of substantial cash compensation. In a public corporation, it is used to get key employees to perform in a manner that will cause the value of the stock to increase in the public market. In closely held corporations, stock compensation may have less value if there is no market in which to sell it. Sometimes its value to the key employee lies in the promise or hope of a sale of the company, a public offering of its stock or a price determined by a buy-sell agreement. Equity-based compensation may be structured to provide tax advantages of the employee based upon the differential between the maximum tax rate on net long-term capital gains, now 20%, and the maximum tax rate on earned income, 39.1%.

Restricted stock and Section 83

When an employer grants stock subject to restrictions, the employee is taxed under Section 83 of the Internal Revenue Code when the stock becomes transferable or is no longer subject to substantial risk of forfeiture. Its value is determined without regard to any restrictions other than nonlapse restrictions. Property is subject to a substantial risk of forfeiture if rights to its full enjoyment are conditioned upon performance of substantial services. An example would be selling stock to an employee for a nominal price on condition that it be returned at that same price if the employee fails to remain with the employer for a specified period.

If stock is subject to a substantial risk of forfeiture, the employee can file an election under Section 83(b) to treat it as if it is vested for federal income-tax purposes when it is transferred. The employee is taxed upon receipt for its excess value, without regard to the forfeiture restriction, over the amount he paid for it. This makes sense if the value is expected to appreciate substantially. However, it accelerates payment of the tax. The employee must file a statement with the IRS electing Section 83(b) treatment within 30 days of the transfer and must also give a statement to the employer.

* Example 1: On June 1, 2002, Employee A receives company stock that has a fair market value of $50,000. He pays $30,000 for it. If he leaves the company within two years, he is required to return the stock to the company for the lesser of $30,000 or its fair market value at that time. He does not recognize any income at receipt of the stock. On June 1, 2004, when the stock becomes vested, it has a fair market value of $100,000. The employee recognizes $70,000 of ordinary compensation income ($100,000 fair market value of the stock on the date it becomes vested minus the $30,000 he paid for it).

* Example 2: Employee B files an election under Section 83(b). She recognizes $20,000 of ordinary compensation income on June 1, 2002 ($50,000 fair market value of the stock when transferred to her minus the $30,000 she paid for it). She does not recognize any income when the stock becomes vested on June 1, 2004. Future appreciation in the value of the stock is eligible for long-term capital-gains treatment.

* Employer's compensation deduction: The amount included in income under Section 83(b) is deductible by the employer in the taxable year in which or with which ends the tax year of the employee. Under prior regulations, for employees, wage withholding was a condition to deductibility. This requirement has been eliminated and replaced with a reporting requirement for the employer.

Incentive stock options

An incentive stock option is a qualified right to purchase stock at a fixed price. To qualify, an option must satisfy a number of requirements under Section 422. The price must not be less than the fair market value of the stock on the date the option is granted.

* Example 3: The company has 100,000 shares outstanding on Jan. 15, 2002, when each share is worth $10. On January 15, 2002 it grants Employee B options to buy 1,000 shares at $10 per share, exercisable anytime before Dec. 31, 2011. Its value has increased to $20 per share when the employee exercises the options on July 1, 2003, and tenders the company $10,000 for 1,000 shares. Employee B begins her holding period on July 1, 2003, for long-term capital-gains treatment upon sale of the shares.

* Tax consequences of incentive stock options: If all requirements are satisfied, there are no tax consequences to either the executive or the employer upon the grant of the option. No income tax is imposed upon the employee when the option is exercised, and no deduction is permitted to the employer.

To the extent that the aggregate fair market value of stock (determined on the grant date) to which incentive stock options are exercisable for the first time during any calendar year exceeds $100,000, the excess options are not treated as incentive stock options. If the employee disposes of the stock before expiration of specific holding periods (two years of the grant date or one year after the exercise date), the employee must recognize income and the company is entitled to a corresponding deduction in the tax year when the disqualifying disposition occurs. The employee's basis in the stock (for determining the amount of gain upon any subsequent disposition) is the exercise price of the stock, if it was paid in cash on the basis of any shares surrendered in a "cashless" exercise.

* Alternative minimum tax consequences of incentive stock options: The amount of gain that is not recognized by the optionee upon the exercise of an incentive stock option is included in alternative minimum taxable income, subject to an alternative minimum tax of 26% to 28%. For these purposes, only the alternative minimum taxable income recognized upon the exercise of an incentive stock option is added to the basis of the stock received. When the stock is sold, the alternative minimum tax that was paid is available to offset any capital-gains tax due. This prevents the executive from having to pay a double tax.

Nonqualified stock options

A nonqualified stock option is any stock option that does not qualify as an incentive stock option. The optionee generally recognizes income upon exercising the option, and the employer receives a corresponding income-tax deduction. Because nonqualified stock options do not qualify for favorable income-tax treatment, there are no special qualification rules that apply.

* Grant of option: A nonqualified stock option normally does not have a readily ascertainable fair market value unless it is actively traded on an established market. If it does not have this fair market value, there are no tax consequences to the executive receiving the grant.

* Exercise of the option: If the option does not have a readily ascertainable fair market value, then the optionee is taxed upon the spread -- the difference between the fair market value of the stock on the date of transfer and the amount paid for it.

The employee's basis in the stock acquired upon the exercise of the nonqualified stock option is the amount paid for the stock, as well as any income recognized upon the exercise. Thus, the optionee has a basis equal to the fair market value of the stock at the time the option was exercised.

* Example 4: The company grants Employee C nonqualified stock options on March 1, 2002, to buy 10,000 shares at $10 per share, fair market value then. On July 1, 2003, he exercises the options and tenders $100,000 to the company in payment of the exercise price. Since the stock is now worth $20 a share, he recognizes income of $100,000. He has a basis in the option shares of $20 per share and begins his holding period on July 1, 2003, for purposes of long-term capital gains treatment upon sale of the shares.

* Employer's deduction: The employer is entitled to a deduction equal to the income recognized by the optionee upon the exercise of the options. It is conditioned, however, upon the employer deducting income-tax withholding on the amount of income, unless the optionee is an independent contractor.

Conclusion

The structure of equity-based compensation requires advice from corporate counsel, tax professionals and employee-benefits consultants. Public companies have departments devoted to the administration of these plans, ensuring compliance with tax and securities-law reporting requirements. Closely held employers should consult skilled advisers in structuring equity-based compensation to avoid unnecessary tax consequences to employees receiving the benefits. In many cases, the improperly designed plan can be tuned up and corrected prior to a tax disaster. Like visiting the doctor or dentist, the checkup cannot provide an effective diagnosis or cure if it is too late.

C. Wells Hall III

C. Wells Hall III is a partner in the Tax Transactions Practice Group of the Charlotte office of Mayer, Brown, Rowe & Maw, an international law firm with 1,300 attorneys. He has extensive experience in structuring equity-based compensation arrangements and business tax planning, including the tax aspects of mergers and acquisitions. A graduate of N.C. State University, he received his law degree from Duke University.