by George G. Jones and Mark A. Luscombe

Employers have long had an interest in crafting compensation packages that not only will attract key talent but also will encourage them to stay with the company and work to improve it.

Cash is always attractive to employees, but is often in short supply and does not provide any long-term ties or incentives. Deferred cash compensation can provide the incentives and long-term ties, but employees may want to know that the cash will be there and insist that vehicles, such as Rabbi trusts, be created to at least improve the odds that the money will eventually be available to them. Therefore, even deferred compensation may put a strain on cash resources.

Stock options were, until recently, the compensation vehicle of choice - relatively easy for the company to offer and relatively attractive to employees who saw the potential for appreciation. The declines in the stock market over the last three years, however, have diminished their appeal. The growing trend toward expensing stock options for accounting purposes also reduces their attractiveness to employers.

These factors, combined with the recent reduction in marginal tax rates, even more significant reductions in capital gain tax rates, and still even more significant reductions in dividend tax rates, have left employers and compensation planners searching for new compensation models.

One that has been around for a long time but that is receiving renewed attention is restricted stock. Microsoft has recently announced a shift from stock options to restricted stock for its employees.

Definition of restricted stock

Although stock, particularly in closely held companies, is often issued with restrictions on transfer, the term “restricted stock” for tax purposes refers to stock issued as compensation that is subject to a substantial risk of forfeiture. The employee does not receive outright ownership until specified conditions are satisfied.

A substantial risk of forfeiture exists if the right to the property depends on the future performance (or refraining from performance) of substantial services by a person, or the occurrence of a condition related to the transfer. Common restrictions might include remaining with the company for a specified period of years or achieving certain objective performance goals.

Restricted stock has a different meaning in the context of securities law, where it refers to stock received in a private offering not registered with the Securities and Exchange Commission. Restricted stock for tax purposes may also be restricted stock for securities laws purposes, which may affect the rights of the employee on the ultimate disposition of restricted stock received.

The employee receiving restricted stock is entitled to the immediate right to receive dividends and to vote stock during the period the stock is subject to forfeiture.

The employee is required to make no investment with respect to the stock, and the stock is not taxable to the employee until the restrictions constituting a substantial risk of forfeiture lapse. The employee receives the stock regardless of its market value, although the stock is taxable to the employee at ordinary income rates based on its fair market value when the restrictions lapse.

The favorable tax treatment of dividends under the Jobs and Growth Tax Relief Reconciliation Act of 2003 will tend to reward actual stock in the hands of employees rather than stock options or stock appreciation rights.

Code Sec. 83(b) election

Code Sec. 83 governs the treatment of stock or other property received as compensation for services. It provides that an employee is not taxed on the compensation income until the restrictions on the stock are no longer applicable, or until the stock can be transferred free of the restrictions, whichever is earlier.

However, if the stock appreciates between the time that it is granted and the time the restrictions lapse, that appreciation is also taxed as compensation income to the employee when the restrictions lapse.

A Code Sec. 83(b) election permits the employee to elect to be taxed on the restricted stock at the time of grant. The election must be made no later than 30 days after the date of grant. The advantage for the employee is that all future appreciation in the stock is then taxed at capital gain rates rather than ordinary income rates.

This has become even more significant under the Jobs and Growth Tax Relief Reconciliation Act of 2003, with the marginal rates declining by, at most, 3.6 percentage points while the capital gains rates declined by 5 percentage points. The employer gets an earlier deduction corresponding to the time that the employee includes the value of the stock in income, but it may be a smaller deduction than the employer would have been entitled to later if the stock had appreciated when the restrictions lapsed.

One disadvantage of a Code Sec. 83(b) election is that the employee is taxed earlier than would otherwise be required, and taxed at a time when the employee may still be restricted from selling any shares to raise money to pay the taxes owed.

Further, if the stock declines in value before the restrictions lapse, the employee will have paid a tax at ordinary income rates that may produce, on sale, only a capital loss.

Also, if the stock is ultimately forfeited due to the restrictions, the employee is not permitted a deduction for the taxes paid in conjunction with the 83(b) election, but could treat the forfeiture as a sale generating a capital loss.

Restricted stock vs. options

Both restricted stock and stock options can be used as employee incentives. Historically, the primary restriction on restricted stock has been a time-in-service requirement. Stock options, by their nature, have rewarded an increase in stock price because they only become valuable if the stock price goes up.

Restricted stock actually gives the employee something of value, subject to losing it, while a stock option only gives the employee the potential to receive something of value if the company’s stock does well.

One of the problems with Microsoft’s current stock option program is that many employees have a strike price on their stock options that is above the current fair market value of the stock, and the options are therefore worthless both as a matter of fact and as an immediate incentive. Restricted stock has the positive potential to help employees focus on the long-term performance of the company rather than short-term fixes to artificially raise the price of the stock temporarily.

Employers in the future may create more performance-based restrictions on restricted stock rather than just time-in-service restrictions, as Microsoft is doing for its executive group, while only imposing a time-in-service requirement on its rank-and-file employees.

One prior advantage of stock options over restricted stock was that stock options did not have to be expensed. As companies increasingly move toward expensing options, this advantage will tend to disappear. There is a group trying to hold out against the expensing trend, however, arguing that stock options are too difficult to value and that they represent a dilution of shareholder value, not a cost to the company.

The IRS has also recently identified certain transactions involving stock options as abusive transactions under its tax shelter guidance. These transactions involve the transfer of non-statutory compensatory stock options to a related person, typically a family member or family limited partnership, in return for a long-term, unsecured promissory note.

The plan was intended to justify a deferral of taxes related to the option until the note was satisfied. Identifying a transaction as a listed transaction increases the reporting and disclosure requirements.

The recent tax law changes, while benefiting restricted stock, also tend to benefit stock options. Incentive stock options would fully qualify for the new capital gains rates, while non-qualified option recipients could also take advantage of the Code Sec. 83(b) election to increase the portion of appreciation that would qualify for capital gain rates.

Future of restricted stock

Most compensation planners tend to view restricted stock as a part of an overall compensation plan, but whose characteristics do not necessarily outshine other forms of compensation.

Although restricted stock may be hot for a while, in the long term, it is likely to still play only a shared role along with cash, stock options and other fringe benefits in forming an executive compensation package.

Restricted stock has typically only required executives to stay with the company for a certain period of years for the restrictions to lapse. Microsoft intends to tie restricted stock issued to its executive group to certain performance criteria, but it is hard for many to see how restricted stock tied to performance criteria will necessarily perform any better than stock options that are tied to performance criteria.

The role of restricted stock as a means of compensating rank-and-file employees has not been common in the past and is not likely to become common in the future. Microsoft is embarking on such a program in large part to help those employees who currently hold worthless options.

Although Microsoft is implementing a restricted stock plan for a broad range of employees, performance restrictions, as opposed to time-in-service restrictions, are only being imposed on its executive group. Microsoft hopes that this approach will provide a more stable long-term incentive to its employees.

In this role, restricted stock is fulfilling a role that is similar to that served by employee stock ownership in other companies, such as Wal-Mart, which has sought to promote broad-based employee stock ownership. The forfeiture period tends not so much to provide an employee incentive as to keep stock ownership restricted to employees who have at least made a significant commitment of years to the company.

The lower capital gains and dividend rates will tend to make employees more receptive to stock ownership, but the incentives that are associated with stock options may likely still prove to be the stronger motivator.

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