Restricted Stock Basics

Restricted stock is a common way that companies put equity in the hands of their employees. Like stock options, the employee receives a grant (also called an award) from the company, in most cases he doesn’t pay anything for the grant, and usually it vests over time.  But there are important differences between stock options and restricted stock.

What is restricted stock?

Restricted stock is shares of a corporation, issued by the company to a service provider (an employee, director, consultant, advisor or other person), with restrictions on transfer and a risk of forfeiture until specified vesting conditions are met. 

The shares are owned by the recipient beginning on the grant date, giving the recipient the right to vote the shares and receive dividends (although the award can stipulate that dividends will be held in escrow until the shares vest) and starting the holding period for capital gains purposes. 

If the recipient leaves the company’s employment (or director services or other relationship, as applicable) before the shares vest, the company has the option, generally exercisable for several months, to take back the unvested shares, generally for no compensation or for a nominal payment. 

This kind of restricted stock should not be confused with a different concept by the same name in the context of public companies. When outstanding shares of a publicly-traded company are not registered for resale and have no available exemption from the registration requirement, or are contractually restricted from transfer, these are also called “restricted” securities. I am not discussing those here. 

How is restricted stock awarded?

State corporation laws require that any issuance of the corporation’s stock, including restricted stock, to be approved by the corporation’s board of directors or an authorized committee. While a shareholder-approved plan is not required for restricted stock awards of privately-held companies (as it is for incentive stock options), it is a best practice to have such a plan, and it is very easy to implement one.  In its authorizing resolution (by live meeting or unanimous written consent), the board or committee must determine (1) the number of shares and (2) the vesting conditions, and it is highly advisable for the board or committee also (3) to make a determination of valuation, even if it is confirming a valuation determined earlier. 

How is it documented?

The company prepares a restricted stock agreement.  This includes: 

 - Vesting terms; 

 - A mechanism for the company to buy back the shares cheaply, or for no payment at all, if the recipient leaves the company before vesting;An escrow letter appointing a company officer, usually the secretary or treasurer, as escrow agent to hold the stock certificate until vesting (and the certificate for unvested shares should remain in the company’s control until then); and 

 - A stock certificate issued in the name of the recipient (but retained by the escrow agent until vesting). The stock certificate bears a restrictive legend that refers to the restricted stock agreement (which can be stapled for easy removal by the escrow agent at the time of vesting). How is restricted stock taxed?

When restricted stock is granted in exchange for some kind of past or future services (which is almost always the case), the United States Internal Revenue Services considers the fair market value of the stock (less any amounts paid for the stock, which is usually zero) taxable compensation.  (If the recipient is located in another country, this entire discussion may not be applicable and you should get local tax and securities advice before making an award.)  And because restricted stock is almost always subject to a “substantial risk of forfeiture” (subject to vesting, that is), the recipient may elect, within 30 days of grant, to make a “section 83(b) election” with the IRS. More on section 83(b) in a moment. And of course, as with any equity compensation, Section 409A of the Internal Revenue Code may be implicated. 

If the recipient accepts the award and does nothing else, at grant there is no taxable event for the recipient or the company.  But when part of the award vests, the recipient pays ordinary income tax, and company receives deduction, on the fair market value of the vested portion, valued on the vesting date (not the grant date). So if the value of the company and the shares rises between the grant date and the vesting date, the taxes will also go up.  And just because a restricted stock award vests does not mean the stockholder will have cash to pay the taxes – if the company is not publicly traded, the stockholder probably won’t have liquidity and will have to find another way to satisfy the tax man.  This can be a terrible surprise for people who don’t understand the tax rules and don’t plan ahead.

If the recipient instead makes a section 83(b) election, which must be sent to the IRS within 30 days of the grant date, he can pay ordinary income tax (and the company would receive a corresponding deduction) on the fair market value of the entire award on the date of the award – that is, in the current tax year.  Someone would make this election if the current value of the company is low enough that the value of the award and the resulting taxes are small and manageable, and especially if he expects the value of the company to climb (and which investor or start-up employee doesn’t?). But if the shares never vest – such as when an employee quits before vesting and the company elects to take back the shares – there is no refund of those taxes paid.  A section 83(b) election is a wager that the value of the shares will grow sufficiently to outweigh the risk of paying taxes on shares that never vest.  

Section 83(b) elections are attractive when the company is young and valuations are still low.  Making an 83(b) election also begins the holding period for capital gains treatment, which is another primary benefit of this approach.  Without an 83(b) election, the holding period for capital gains treatment doesn’t begin until the shares vest.  

When the company is mature and its prospects for appreciation are less dramatic, as with most public companies, a section 83(b) election might not make sense.  In between …well, that’s what you have financial advisors and accountants for.

© 2013 by Robert G. Schwartz, Jr. All rights reserved Disclaimer: This summary is provided for educational and informational purposes only and is not legal advice. Any specific questions about these topics should be directed to an attorney.