sacramento-ca-business-transfer-shares-restricted-stock-estate-planning-attorneyMany corporations seek to transfer shares to key employees or family members without requiring the recipient to pay for the shares. One way to accomplish this goal is to transfer the shares as compensation for labor or services actually rendered by the family member or key employee. The benefit to the Corporation is that the value of the share transfer is a deductible expense, similar to salaries and wages, but the employee or contractor must report the value of the stock transferred as ordinary income. IRC § 83.

Restricted stock refers to stock that is transferred to an employee as compensation for services, but is subject to a vesting schedule or some other form of restriction of ownership. The timing and amount of the employee's reportable income is dependent on the vesting schedule. The employee does not report income on the value of stock received in connection with the performance of services until the transfer is substantially vested in the employee or contractor. The use of restricted stock also provides non-tax benefits to the Corporation. Vesting schedules attached to the stock transfer provide an incentive for employees to remain with the Corporation until the stock is fully vested, and the potential for future appreciation in the stock's value serves as a powerful performance incentive for all employees who are shareholders.

Internal Revenue Code ("IRC") § 83 governs the taxation of restricted stock. Under IRC § 83(a), the employee or contractor reports as his or her gross income the fair market value of the stock transferred in return for services, less any amount the employee or contractor may have paid for the stock. The employee does not report the income until the stock is fully vested or there is no "substantial risk of forfeiture". Therefore, under a five-year step vesting schedule, the employee or contractor may report 20% of the value of the stock each year as income as it vests. The Corporation takes its expense deduction as it reports income to the employee or contractor.

IRC § 83(b) provides the employee or contractor with the ability to elect to include the entire value of the stock in the year of the transfer, rather than waiting until the stock vests. When an IRC § 83(b) Election ("83(b) Election") is made, the income is based on the fair market value at the transfer date, instead of the fair market value at the vesting date. Under an 83(b) Election, no further income is recognized by the employee until the stock is sold, when the employee reports capital gain. The advantages of an 83(b) Election arise when the stock value increases, and more of the appreciation is taxed as capital gains rather than ordinary income. Also, the holding period begins at the grant date instead of the vesting date. Therefore, after the first year of the transfer, sales of the stock by the employee as it vests immediately qualify for long-term capital gain treatment. The disadvantages arise upon the immediate income taxation of the entire transfer. This is particularly disadvantageous when the stock declines in value over time, or when the stock is forfeited because the restrictions are not met. An 83(b) Election may not be revoked without approval from the Internal Revenue Service.

If no 83(b) Election is made by the employee, the Corporation's dividends paid on the restricted stock are also treated as compensation. The employee reports the dividends as gross income, and the Corporation is allowed a deduction on the dividends. But if an 83(b) Election is made, the employee is able to treat the income as dividend income. As such, the Corporation may not claim the deduction.

The information in this article is not, nor is it intended to be, legal advice. This article is for informational purposes only and may or may not apply to you. You should consult an attorney for advice regarding your particular circumstances. We invite you to contact us and welcome your calls, letters and electronic mail. Contacting us does not create an attorney-client relationship. Please do not send any confidential information to us until such time as an attorney-client relationship has been established.