What is Restricted Stock?
Restricted stock is stock (i.e. actual stock, not options) that is “substantially nonvested”, which in turn means that the stock is subject to – both – a “substantial risk of forfeiture” and the stock is non-transferable. Substantial risk of forfeiture means that the company has a right to repurchase the stock at less than fair market value if the grantee leaves the company or if, as Charles A. Wry, Jr. writes, the grantee “ceases to perform substantial services (or if there is otherwise a failure of a condition related to a purpose of the transfer).” Stock is non-transferable for as long as it may not be transferred free of a substantial risk of forfeiture.
What Significance If Stock is “Restricted”?
Internal Revenue Code Section 83 governs tax consequences of grants of stock and options by companies to employees and nonemployees. As the Journal of Accountancy noted earlier this year,
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.
Thus, the significance of restricted stock is to defer recognition of income received by virtue of the grant of such stock. Once no longer deemed “restricted”, the grant of stock is then subject to income tax payment requirements. Once either of the 2 restricted stock conditions lapses, the stock is no longer “restricted”.
Who Can Receive Restricted Stock?
Employees and non-employees (including contractors, freelancers, vendors, etc.).
How is Restricted Stock Paid For? What Tax Implications – To Grantees? To the Company?
If the stock has value, then the grantee is required to pay fair market value for purchase of the stock (unlike options). Otherwise, the grant of the restricted stock will be deemed taxable compensation. 2 points about this:
(1) Startup Companies. With new companies with startup value, the stock may not yet have value, so the cost to purchase the stock may be negligible.
(2) When Taxable? Even if the grant of restricted stock is taxable compensation, the tax isn’t actually owed by the grantee until the vesting restrictions lapse. At that point, tax is owed as compensation at ordinary income rate. Ordinarily, the company gets a business compensation deduction when the restrictions lapse.
But even that comes with a caveat (Section 83(b) Election): The grantee may elect to recognize income immediately (rather than post-vesting and post-appreciation) at the time of receiving the stock grant, by filing a notice with the IRS of election under Section 83(b) of the Internal Revenue Code. The notice must be filed within 30 days of the grant of restricted stock. If a Section 83(b) election is made, then tax is payable in the tax year the grant is received, based on the fair market value of the underlying stock.
The Journal of Accountancy published earlier this year an excellent discussion of Section 83(b)’s election process, tax benefits and risks as they relate to restricted stock. The first obvious downside is the requirement to pay tax now, but that can be a gamble worth making if expectations are for substantial appreciation of the value of the underlying stock – and thus higher tax owed later. Of course, another downside of electing to pay the tax now is that the stock is still “restricted” for the full holding period and thus subject to forfeiture. So one could end up electing to pay the tax upon grant (rather than later) and still losing the stock through forfeiture with no refund of the tax.
If the grantee makes a Section 83(b) election, the company may take its compensation deduction immediately.
Major (Philosophical) Distinction between Restricted Stock and Options?
With restricted stock, the grantee becomes an actual shareholder immediately (although not for tax purposes unless the grantee makes a Section 83(b) election). The stock is actually issued to the grantee, subject to vesting and company repurchase rights. The grantee is thus a true “shareholder” with all rights of equity owners (voting rights, distribution rights, information rights, etc.).
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