An employee's compensation can be paid in either cash or noncash property. It is common for an executive's compensation to include payment in property, usually employer stock or securities, that is subject to some form of restriction at the time it is paid. The restriction on the property is usually designed to serve an employer goal, such as retaining a valued employee, and the restriction also can be designed to postpone taxability of the compensation to the employee and correspondingly postpone the employer's tax deduction.
Restricted stock or other restricted property is not an attractive benefit to an executive if the executive must pay income tax on the property when it is received, even though it is subject to restrictions. Therefore, most restricted property plans are designed around Code Section 83 that allows deferral of taxation to the employee if the restrictions meet certain requirements. Basically, the rules provide that an employee is not subject to tax on the value of restricted property until the year in which the property becomes substantially vested. Property is not considered substantially vested if it is subject to a substantial risk of forfeiture and not transferable by the employee free of the risk of forfeiture. As with most types of nonqualified compensation plans, the employer does not get a tax deduction until the year in which the property becomes substantially vested and includable in the employee's income.
The question whether there is a substantial risk of forfeiture depends on the facts and circumstances of each case. However, a substantial risk of forfeiture usually exists when the employee must return the property if a specified period of service for the employer is not completed-for example, five years of service. A forfeiture that results only from an unlikely event, such as the commission of a crime by the executive, probably would not constitute a substantial risk of forfeiture. Forfeitures as a result of failing to meet certain sales targets or going to work for a competitor could constitute substantial risks, depending on the facts and circumstances. If the employee is an owner of the company, the IRS is likely to be skeptical of any forfeiture provision in the plan, no matter how rigid it may appear on paper.
The nontransferability provision-the second half of the test-can be complied with in the case of the company stock by inscribing a statement on the share certificate to the effect that the shares are part of a restricted property plan. Thus, any prospective transferee is aware that the employee is not free to sell the shares to an outsider without restriction.
Suppose that executive Rita Bill is permitted to buy 500 shares of company stock at $10 per share in 2000, while the current market value is $100 per share. Rita must resell the shares to the company for $10 per share if she terminates employment with the company at any time during the next five years. The share certificates are also stamped with an appropriate statement to meet the nontransferability requirement. Rita pays no taxes on this arrangement until the restriction expires in 2005. If the unrestricted shares in 2005 have a market value of of $200 per share, Rita will have additional taxable compensation income for 2005 of $100,000, the market value of the shares, less $5,000, the amount Rita paid, or a net additional compensation income of $95,000. The company will get a tax deduction of $95,000 in 2005, but gets no deduction for 2000. Also, the allowance of the tax deduction to the company is, like all tax deductions for compensation paid, subject to the requirement that the total compensation package for the employee constitutes reasonable compensation for services rendered.
Many variations are possible in the design of restricted stock plans. The plan, for example, may provide that dividends on the restricted stock are payable to the executive during the restriction period; if so, these dividends are taxable currently to the executive as compensation income. The plan also might provide graduated vesting over a period of years, rather than full vesting at the end of a specified period like five years; this would mean that the executive would be taxed each year on the value of the property that became substantially vested that year.
In some plans, there are no forfeiture provisions; instead the stock is subject to other restrictions. For example, the employee may have a fully vested interest in the stock but may not be permitted to resell the stock without first offering it back to the company at a specified price. In that case, the value of stock to the executive would not be its market value, but would be a reduced value reflecting the restriction. Under the Internal Revenue Code, a restriction will be taken into account in valuing the property for tax purposes only if it is a nonlapse restriction-a restriction which by its terms will never lapse. The restriction in the example with a requirement of resale to the company at a fixed price would qualify as a nonlapse restriction. Other types of restrictions must be assessed on their own facts and circumstances, and the IRS tends to take a very limited view of what constitutes a nonlapse restriction.
Once an executive has become substantially vested in the restricted property and paid any tax on the compensation element involved, gain on a subsequent sale of the property is usually taxed as capital gain just as in the case of the sale of such property acquired by other means.
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