Frequently asked questions about restricted stock

May 09, 2021
Federal tax Compensation & benefits

Various equity compensation arrangements, like incentive stock options or nonqualified stock options, can reward employees, increase engagement and enhance company performance. Employers use restricted stock as a way to motivate employees by giving them an equity stake in the company, subject to certain vesting conditions or restrictions. The following are answers to some of the common questions that employers have about granting restricted stock.

Q. What is restricted stock?

A. As the name suggests, restricted stock is actual company stock (in contrast to phantom stock) paid to employees (or contractors, although we will refer to employees throughout this article) with some restrictions. The restrictions must generally be related to the performance of future services, either a time or performance vesting condition which gives rise to a risk of forfeiture until the conditions are satisfied. For example, a company may grant stock in one year that does not vest for three years, which subjects the stock to the condition that the employee remain employed by the company for that time in order to possess a vested right to the stock. If the employee terminates employment prior to the end of the three years, the employee forfeits the stock back to the company. Thus, the condition the employee remains employed for three years creates a risk of forfeiture to the employee that will not lapse until the condition, three years of employment, is satisfied.

Q. For a private company, how is the value of the stock determined?

A. The value of restricted stock is measured by the value of the company stock. The value may be stipulated, measured by an express written formula, or determined by appraisal of the company.  The value of the restricted stock may fluctuate from year to year as the value of the company changes, because it is an actual share of the company. For example, if the company has a bad year, the value of its stock, and the value of the restricted stock, may decrease. Thus, regardless of any vesting schedule, there is no locked-in value inherent in the restricted stock.

In addition, companies should be aware that events outside the company’s control can also affect its value if a third-party appraisal is used. For example, the tax rate decrease from the Tax Cuts and Jobs Act increased company valuations, all else held equal, because companies have more cashflow as a result of lower taxes; similarly, a major event like the coronavirus pandemic affected market values for many companies. This valuation fluctuation may not discourage the use of a third-party valuation, but it should at least be understood by companies.

Q. How is restricted stock treated for income tax purposes?

A. Full ownership of the restricted stock is transferred at grant, but is subject to vesting conditions until the risk of forfeiture lapses. As long as the risk of forfeiture is considered substantial under the tax rules governing stock compensation, the employee will not be taxed until the conditions are satisfied and the employee is vested in the stock. Upon vesting, the value of the restricted stock is taxed as compensation to the employee, and is subject to income tax withholding and applicable payroll taxes. The employer receives a corresponding deduction in its tax year which includes Dec. 31 of the year in which the employee recognizes the income. The amount of income and deduction is the difference between the fair market value (FMV) of the stock received on the vesting date and the amount, if any, the employee paid for the stock.

Q. Is a section 83(b) election available?

A. Yes. By making a section 83(b) election within 30 days of receiving the restricted stock, employees can include the value of the stock on the grant date, less any amount paid for the stock, as compensation at the time of grant, despite the fact that the rights to the stock have not yet vested. The employer is then entitled to a corresponding deduction in the year of grant equal to the amount of compensation reported by the employee. After making the election, the employee is treated as owning the stock, a capital asset, even though he or she must still satisfy the associated vesting conditions before possessing a nonforfeitable right to the stock. The future appreciation in the stock is taxed as capital gains, instead of compensation, and the holding period begins from the date of the election.

Q. Can dividends be paid on restricted stock?

A. Yes. If an employee receives dividends from substantially nonvested restricted stock, the amounts are considered additional compensation that must be included as income and are subject to withholding and employment taxes. The corporation may take a deduction for the same amount. Once the restricted stock award vests, the dividends are treated as dividend income rather than compensation. On the other hand, if the employee makes a section 83(b) election, the dividends are treated as dividend income rather than compensation immediately.

Q. What are the payroll tax consequences of restricted stock?

A. Equity compensation, such as restricted stock, is subject to Federal Insurance Contributions Act (FICA) taxes. Payroll tax withholding is required at the time of vesting unless a section 83(b) election is made; in which case, withholding should be done at the time of grant. Parties are sometimes caught off guard by this implication because it is a noncash payment; nonetheless, withholding applies and is often planned for when the restricted stock plan is written so that parties are aware of how the withholding will be collected.

Q. Are there any section 409A concerns for restricted stock?

A. No. Section 83 taxes restricted stock at the time of vesting (or on the grant date if a section 83(b) election is made). As a result, there is no deferral to which section 409A could apply.

Q. May loans from the employer be used to purchase restricted stock?

A. Yes, however, there are additional considerations for the loan to be respected as such and for the stock to be treated as transferred for tax purposes.  

Generally, the loan should have stated interest, a repayment schedule with a real expectation of repayment and terms that are in writing and enforceable. There is risk that a fully nonrecourse loan with the stock held as collateral is treated only as an option to purchase the stock in the future so employers should get tax advice when providing employees loans to purchase stock from the employer.

Q. Is a restricted stock unit the same as restricted stock? How are restricted stock units taxed?

A. No. Economically, a restricted stock unit (RSU) is very similar to restricted stock. Certain vesting conditions are attached to actual equity that gives employees a right to ownership after those conditions are satisfied. The difference with an RSU is that the stock is not transferred until after the vesting conditions are satisfied and the risk of forfeiture has lapsed. Therefore, the employee never holds the stock when it is subject to a risk of forfeiture, and thus, a section 83(b) election does not apply to RSUs. The general tax consequence of the FMV over the price the employee pays being compensation at the time of vesting (or future transfer of the shares) is the same as restricted stock. However, RSUs can have deduction timing and section 409A considerations that differ from restricted stock.

Q. What should a company consider when designing a restricted stock plan?

A. Because restricted stock is a noncash method for incentivizing certain performance from key employees, companies should consider the following when formulating aspects of their written plan:

  • What key employees should receive equity in the company?
  • Should there be a separate class of stock for employees (if a separate class is allowable per other rules) or should they have the same class as other owners?
  • What type of vesting conditions will most incentivize employees?
  • Do employees have enough cash to cover the required tax upon vesting (or upon a section 83(b) election)?  Where will the cash to cover tax withholding come from?
  • How will employees receive liquidity from the stock?  Is there a buy-sell agreement in place or should there be?
  • Will the employee make an section 83(b) election?
  • Will special vesting rules apply in the case of death, disability or other events?
  • When will restricted stock be granted and how many shares are appropriate?
  • Should shares be awarded outright or should employees pay something for them?

The attributes of restricted stock should be compared to other incentive compensation methods to determine if they properly meet the company’s goals and, if they do, the plan should be reviewed with tax advisors so that no unintended tax consequences occur..

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