Recent tax law changes have altered the landscape.

In the not too distant past, stock options were the preferred method of giving employees an equity interest in their employer. However recent changes in the tax laws, and the announcement by Microsoft Corporation that it will grant restricted stock instead of options to its employees, have called this practice into question. In light of these changes, this article examines the different requirements and tax consequences to the employee and employer of various types of incentive compensation, and will suggest why granting restricted stock, rather than options, may be the preferred route for many companies.

Restricted Stock

When an employer transfers restricted stock to an employee or independent contractor, there is no current tax to the employee. Instead, the excess of the fair market value of such stock over the amount, if any, paid by the employee is includible in his ordinary income, and is deductible by the employer in a later year, when such property is no longer subject to the restrictions. A typical restriction is that the employee must continue to be employed by the employer for a specified period of time, although companies may impose revenue or earnings targets as well.

Often, restricted stock vests in increments. When this occurs, the excess of the value of the newly vested shares over the amount paid, if any, for those shares is includible in income at that time. Since fair market value is determined at that time, any appreciation in the stock up to the vesting date is taxable to the employee in that year as ordinary income, without regard to whether the stock can be sold at that time because of the absence of any public market for the stock. Any future appreciation may be taxed at favorable capital gains rates.

In the private company context, this can cause multiple headaches. The employee must pay tax at ordinary income rates on an increasingly larger amount if the stock price is rising, without an ability to sell any of the stock to cover the tax bill. The employer has the administrative burden of determining the fair market value of the stock at each vesting period. Not surprisingly, most privately held companies will advise their employees, or even encourage them, to file an 83(b) election described below to accelerate the taxable event to the initial grant of the restricted stock

Section 83(b) Election. Section 83(b) of the Internal Revenue Code provides that an employee may elect to include in gross income, in the year in which restricted stock is first transferred to the employee, the excess of the fair market value of the stock at that time over the amount, if any, paid for it. If a Section 83(b) election is timely made, all appreciation after the date of the stock grant will be eligible for capital gains treatment and will not be taxed until the stock is disposed of, regardless of when the restrictions lapse.

Start-up or high-growth companies, which expect their stock to increase in value, often adopt this alternative where the value of the stock is low at the time of transfer or where full value is paid for the stock at that time. The recent tax law changes have generally reduced capital gains rates to 15% from 20%, while ordinary income rates for the top brackets have declined a little less, to 35% from 38.6%, making restricted stock with an 83(b) election filing an even more tax-efficient strategy. However, there are a few drawbacks. First, if the election is made and the property is subsequently forfeited, no deduction may be taken for the amounts previously included as income and the employee will not get a refund on the taxes paid. Second, the employee's payment (if any) for the restricted stock is an investment in his employer. Like all investments, the value of the stock may decline or the stock may become worthless. In essence, the employee is taking some amount of risk, particularly if there is no current market for the stock, in order to obtain a significant tax advantage if the stock becomes worth a great deal some day.

Some employers have considered it advantageous to transfer cash to the employee to pay some or all of the tax on restricted stock (a "gross-up"). Under such circumstances, the cash transferred is also compensation. Other employers loan the employee the amount needed to purchase the stock or pay the applicable tax through a recourse note secured by a pledge of the stock acquired. Of course, there is a downside here too:The employee is responsible for repayment of the loan even if the stock becomes worthless.

Stock Options

Stock options come in two varieties: statutory or incentive stock options (ISOs) and non-statutory (also called non-qualified) stock options.

ISOs. ISOs may be granted only to employees, unlike restricted stock and non-qualified options. If a number of strict requirements are satisfied, any appreciation in the value of the shares from the date of grant of the option is treated as capital gain to the employee. More importantly, the tax is not payable upon exercise but only when the stock is disposed of. However, for alternative minimum tax (AMT) purposes, the excess of the fair market value of the stock over the exercise price on the date of exercise is treated as a preference item.

Since the recent tax law changes reduced the maximum regular income tax rates but left the AMT rates unchanged at 26% and 28%, the tax advantage of ISOs for many employees has been substantially reduced. Further, the favorable tax treatment of ISOs is contingent upon, among other things, the employee's not disposing of the stock received within two years from the date of the grant or one year from the ISO exercise. In practice, only employees with the means to pay both the exercise price of the option and the AMT on exercise are able to meet the holding period requirements. Thus, most employees end up disqualifying their ISOs and getting the tax effect of a non-qualified option.

On the other hand, an employee may exercise an ISO in the first calendar quarter of a year and hold the stock received for the ISO holding period, then sell it to pay his AMT by April 15 of the following year. Although this may be a wise tax strategy, it also entails a year's worth of market risk if the employee stubbornly holds on to a declining stock to avoid disqualifying the ISO. Further, the early sale of some shares will not disqualify the remainder of the option, so all of the intended benefits of the ISO may not be lost.

Unlike the issuance of restricted stock, which results in a deduction to the corporation in the year the employee recognizes income, no deduction is allowed to the employer with respect to an ISO unless the employee makes a disqualifying disposition of the stock acquired (i.e., sells it before the holding period noted above is satisfied). Because of this loss of deduction for the employer and the relatively small tax advantage for the employee when the alternative minimum tax is considered, ISOs are generally not favored by profitable employers.

The employee who receives a non-statutory or non-qualified stock option generally recognizes ordinary income upon the exercise of the option, equal to the difference between the fair market value and the exercise price of the stock on the date of exercise. Once the option is exercised, the stock received is treated as having been purchased on the date of exercise, and generally any future appreciation is, therefore, eligible for capital gains treatment. In effect, the tax consequences of non-statutory stock options are similar to restricted stock for which a Section 83(b) election has not been made. However, they give the employee more control over the timing of income recognition. Because the recent tax law changes have increased the advantages of converting stock appreciation into a capital gain instead of ordinary income, some employers are granting their employees "reverse vest options" that are exercisable immediately for stock which is subject to vesting, just as restricted stock is. The IRS has agreed that an 83(b) election may be filed upon exercising a non-qualified option and receiving restricted stock.

Conclusion

Companies whose stock has a relatively low value will often find it best to issue restricted stock to employees and have the employees make an election under Section 83(b) of the Code to recognize the income immediately upon grant. This may also be true of companies that can benefit from an immediate compensation deduction, even if the value of their stock is relatively high, perhaps combined with a cash bonus or loan to help the employees granted the stock to pay their taxes. For companies with more than nominal stock value, stock options will continue to be useful to grant employees a larger stake in their employers with no immediate tax consequences to the employees, although with generally less favorable tax consequences in the long run. Most important, employers should be very aware of the rapidly changing equity compensation landscape and be prepared to show their employees that they are familiar with, and considering, all of the appropriate alternatives for equity compensation.

Kenneth E. Werner, a partner in the Hartford office of Day, Berry & Howard LLP, focuses his practice on federal income taxation issues arising in business transactions, employee benefits and executive compensation. He can be reached at [email protected]. Andrea M. Teichman, a partner in the Boston office of Day, Berry & Howard LLP, counsels privately held companies on a variety of issues relating to formation and operations, equity and debt financings and mergers and acquisitions. She can be reached at [email protected].