Restricted stock as a benefit plan
Using equity instruments as a form of compensation has been a long standing method of providing incentive and other benefit packages to executive management. However, there’s an alternative to stock option plans: Restricted stock.
What is restricted stock?
Restricted stock is a grant of company stock which the recipient doesn’t have full rights to until the restrictions lapse. As it’s earned and vesting requirements lapse, an employee owns the shares outright and may sell or hold them.
Accounting matters
The accounting for restricted stock is governed by Financial Accounting Standards Board Statement No. 123 (FAS123R, revised 2004), Share Based Payment. FAS 123R defines nonvested shares as “Shares that an entity has not yet issued because the agreed upon consideration, such as employee services, has not yet been received.”
How should restricted stock awards be measured for accounting purposes?Paragraph 21 of FAS 123R states: “A nonvested equity share or equity share unit awarded to an employee shall be measured at its fair value as if it were vested and issued on the grant date. Nonvested shares [restricted stock] cannot be sold.”
What period must the compensation cost be recorded over?
The compensation cost of an equity award is generally recognized over the award’s requisite service period on a straight line basis.
What are the financial reporting advantages?
Unlike stock options, any presumed post grant date stock appreciation isn’t reflected as compensation expense. Furthermore, fewer shares need to be issued, thereby reducing the impact of shareholder dilution.
Tax matters
Is restricted stock taxed to the executive at the date of grant?
Generally no, assuming the grant contains restrictions that subject the executive to “substantial risk of forfeiture” and make the stock “not freely transferable.” It’s when these restrictions lapse at a later date that tax consequences ensue.
When and at what amount will the executive be taxed?
Assuming there’s no Internal Revenue Code section 83(b) election, there’s no taxable event at the date the restricted stock is granted. Instead, the executive is taxed when the restrictions (as previously mentioned) lapse. The amount of income subject to ordinary income taxation would be the difference between the fair market value of the grant on the date the restrictions are lifted less the amount paid for the grant (in this instance assumed to be zero). Upon a later sale of the shares, assuming the shares are held as a capital asset, any additional appreciation in the value of the stock would be a short- or long-term capital gain.
Is there any way to minimize the tax impact to the executive?
Yes. Under the aforementioned 83(b) election, an executive can change the tax treatment of the restricted stock. This election, which must be made within 30 days of the grant date, allows the recipient to include the fair market value of the restricted stock at the grant date as part of their income (without regard to the restrictions). There are no future tax repercussions until the stock is sold. Subsequent gains or losses of the stock would be capital gains or losses.
Will the company receive a tax deduction? If so, at what amount?
The company will have a corresponding tax deduction, in the same amount and at the same time as the ordinary income taxed to the executive. If the executive makes an 83(b) election, this would be at the date of grant; otherwise it will be based on the value of the stock when the restrictions lapse. Capital gains or losses from the sale of the stock by the executive, subsequent to the ordinary income measurement dates, aren’t a tax event for the company.
How will income taxes be treated for financial reporting purposes?
The company will record a tax benefit based on the compensation cost expensed each reporting period in the form of a deferred tax asset at its regular statutory tax rate. As already stated, compensation cost is based on the fair value of the restricted stock on the date of grant.
If the executive makes an 83(b) election, the amount for the tax return benefit and that for financial reporting purposes will coincide. However, there will be a deferred tax temporary difference between the financial statements and the tax return until all compensation costs have been recorded (presumably over the vesting period).
Absent an 83(b) election, the amount of cumulative compensation cost, giving rise to a deferred tax asset, will differ from the future tax deduction because the deferred tax asset isn’t adjusted for a (presumed) increase in the stock value. The excess of the deduction on the tax return over the recorded deferred tax asset will be recorded as additional paid-in capital.
Note: This information is intended to provide an overview of the accounting and tax implications of issuing restricted stock to executives. Companies and individuals should consult with their accounting and tax advisers for specific implementation consequences.
Dale A. Hotz is a managing director with RSM McGladrey. For more information, contact him at dale.hotz@rsmi.com.
