To lure and retain valuable executive talent, employers – especially emerging companies and start-ups – often feel compelled to issue restricted stock as part of the compensation package.
Those key employees are generally reluctant to pay full price for the stock. They also want to defer income recognition on its receipt. And they want any income recognized to be taxed as capital gains rather than ordinary income. Why not? If you don’t ask, you don’t get!
One way companies can answer those concerns is via employer-financed restricted stock sales. But they can also create uncertainty about how and when the employees are taxed. There may, however, be a better solution if the tax problem is faced head-on.
Employees aren’t normally taxed on the grant of restricted stock; instead, they are taxed at ordinary income-tax rates when the stock vests. The taxation is based on the fair-market value of the stock at the time of vesting less any amount paid for the stock.
On a later sale of the stock, after its restrictions have lapsed and ordinary income has been recognized, employees incur a capital gain or loss. But the holding period for determining whether any gain is a long-term capital gain doesn’t start until the restrictions lapse.
Employees, however, can make a Section 83(b) election, which would enable them to accelerate the taxable event to the time the stock is transferred, rather than the time the stock vests. In that way, they can obtain capital-gain treatment, rather than ordinary income-tax treatment, on the appreciation of the stock from and after the date of transfer and during the period the stock restrictions are in effect.
Still, employees will be taxed in the year of transfer at ordinary rates on the difference between the fair-market value of the stock at the time of transfer (determined without regard to the restrictions) and any amount paid for the stock. Any appreciation thereafter would be a capital gain on a later sale, with the holding period starting at the time of transfer.
Most employees are unwilling or unable to pay fair-market value for their restricted stock. Many also dislike the ordinary income-tax hit resulting from appreciation in the stock between the time of transfer and that of vesting. Even the Section 83(b) election proves unsatisfactory to employees who still must pay ordinary income tax at the time of transfer if (and to the extent that) they haven’t paid full value for the stock.
To solve this dilemma for the employees and to serve as a better recruitment tool, companies can lend them cash to finance the purchase price of the stock. Understandably, the employees may be wary of the personal liability associated with a recourse loan collateral. However, if the stock is paid for through the issuance of a nonrecourse loan to the employer secured solely by the restricted stock, the transaction will be treated as the grant of an option to acquire the restricted stock, rather than a “transfer” of the stock.
Without a “transfer” of stock, the Section 83(b) election is unavailable. Thus, the compensation element of the grant remains open, resulting in ordinary income to the employees on the appreciation of the underlying stock until the option is exercised. Capital-gains treatment would then only be available after the option has been exercised. When the “option” is considered exercised (and thus the stock transferred) in this context is far from clear. A large down payment makes it more likely that the stock would be treated as transferred. But there is a significant uncertainty about what amount would be considered enough, thus exposing the employees to a potentially big tax liability. While making the loan partially recourse could solve the problem, the question is still: How much of the loan has to be recourse?
Not to worry. An alternative approach, implicitly sanctioned by the Internal Revenue Service in a series of private letter rulings in 2009, involves the avoidance of this issue altogether. Instead of having the employer finance the employees’ purchase of the stock, the employer finances the employees’ tax liability.
Here is how it works: The employer transfers the stock to the employees at no cost, and the employees make the Section 83(b) election to accelerate the taxable event to the date of transfer. That requires the employees to recognize ordinary income in an amount equal to the value of the stock and enables the employer to report an ordinary noncash deduction equal to the same amount.
The employer then finances the employees’ income-tax liability with a nonrecourse loan to the employees (at today’s low interest rates) secured by the restricted stock. Since this doesn’t involve the financing of the employees’ purchase price of the stock, the restricted stock grant would be considered a “transfer” of the stock, thus closing the compensation element of the transaction upon transfer because the Section 83(b) election is made. This avoids the tax uncertainty created by financing the actual stock acquisition with a nonrecourse loan and the requirement of a substantial cash down payment by the employees or, alternatively, a substantial portion of the acquisition note’s being recourse.
Although employees must still pay the ordinary income tax incurred on the date of grant, they have deferred the payment of the tax by means of the employer’s nonrecourse loan. The employer is permitted a noncash deduction in the same amount and at the same time, while the employees are required to include the compensation element of the restricted stock grant in income.
If the employer has enough taxable income, the resulting tax benefit can be used to finance the nonrecourse loan made to the employees. Thus, the use of a nonrecourse loan to finance the employees’ tax liability associated with the restricted stock grant is a win-win solution for both the employer and the employees. Other than interest payments, neither incurs an out-of-pocket cost on the equity grant to the employees. Of course, the employer still has a decision to make: is the economic cost of the equity granted to the employees a worthwhile cost to incur in gaining key employees’ services?
Gary Q. Michel is a partner at law firm Ervin Cohen & Jessup, in Beverly Hills, California, where he chairs the tax-law practice.