Restricted stock: The Tax Impact On Employers and Employees - Part 3 of 4

G. Edgar Adkins, Jr., and Jeffrey A. Martin of Grant Thornton LLP

Fair market value

In addition to the vesting date, the FMV of restricted stock must be accurately determined to ensure that the proper amount is included in an employee's gross income. If the employee makes a Section 83(b) election, this value must be determined as of the date the restricted stock is granted to the employee. If the employee does not make a Section 83(b) election, the value must be determined as of the date the substantial risk of forfeiture lapses (i.e., the vesting date). The accurate identification of these dates is of paramount importance, especially when the value of the stock is volatile and can change dramatically from one day to another.

Section 83 provides no guidance for determining the grant date in connection with a Section 83(b) election. The IRS, however, has addressed the determination of the grant date in connection with stock options. It seems reasonable to apply the same principles for determining the grant date for restricted stock, since the inherent differences between stock options and restricted stock do not have any effect on this determination.

The IRS has defined the grant date of an incentive stock option as the "date or time when the granting corporation completes the corporate action constituting an offer of stock for sale to an individual under the terms and conditions of a statutory option. A corporate action constituting an offer of stock for sale is not considered complete until the date on which the maximum number of shares that can be purchased under the option and the minimum option price are fixed or determinable."[19] The IRS also has addressed the determination of grant date under Section 409A's rules for nonqualified deferred compensation in connection with stock options and stock appreciation rights. The regulations under Section 409A provide the same definition of grant date as for incentive stock options, with two additional requirements. First, the class of stock must be designated; second, the identity of the employee must be designated.[20]

The application of this guidance to restricted stock is not altogether clear, so it is subject to interpretation and differing views. Nevertheless, it seems clear that the grant date of restricted stock is the date when the granting corporation completes the corporate action constituting a transfer of stock to an individual under the terms and conditions of the restricted stock agreement. Thus, a careful analysis of the restricted stock agreement is important in determining the grant date. If a fuller analogy to the IRS guidance for options and stock appreciation rights is applied, the grant date for restricted stock does not occur until the date on which the number of shares that are transferred and the purchase price (if any) are fixed or determinable, and the class of stock and the employee have been identified.

Several practical issues arise in determining the grant date. Once again, the IRS's guidance for incentive stock options, and for stock options and stock appreciation rights under Section 409A, proves helpful. For example, the grant date can occur before the employee is notified of the grant, as long as there is not an unreasonable delay in notifying the employee after the corporate action is completed. Also, the grant date can occur before shareholders have approved the grant. Finally, the grant date can occur before the approval of, or registration with, a regulatory or government agency, such as the Securities and Exchange Commission, unless the corporate action clearly indicates that this is a condition of the grant.[21]

In determining the vesting date (i.e., when a Section 83(b) election has not been made), the specific provisions of the restricted stock agreement should be carefully reviewed. Under most circumstances, this determination will be relatively straightforward. When complex vesting provisions are used, however - such as some of the performance condition examples discussed above - it follows that the determination of the specific date on which vesting occurs also may be complex.

Once the appropriate date has been determined, attention must be turned to measuring the stock's FMV on that date. Any discussion of FMV must necessarily distinguish between public and private companies. The determination of FMV, a relatively easy process for public companies, is a significant challenge for private companies. Thus, it comes as no surprise that the available guidance focuses largely on private companies.

Despite the importance of measuring FMV, the statute deals with only one relatively narrow aspect of this determination. Specifically, Section 83(a)(1) states that the FMV should be "determined without regard to any restriction other than a restriction which by its terms will never lapse." The regulations refer to this as a "nonlapse" restriction and define it as a permanent restriction that requires the use of a specified formula to determine the value at which the stock is sold.[22]

The examples of such a formula in the regulations include the use of book value and a multiple of earnings per share. Whatever the formula, the employee can sell the stock only at the value that is calculated under the formula. Likewise, a party who purchases stock from the employee must sell the stock at the formula value, because the formula must apply to all subsequent holders of the stock.[23]

This type of restriction truly has the effect of establishing the FMV of the stock, because the stock cannot be sold at any value other than the formula value. The regulations state that the formula value will be considered the FMV unless another value is established to the contrary by the IRS. In this instance, the burden of proof with respect to the value is on the IRS.[24]

Reg. 1.83-5(a) contains a special provision for a formula price based on book value, or a multiple of earnings, or a combination of these two measures. The regulation states that the price "will ordinarily be regarded as determinative of the fair market value." The formula price will not be treated as the FMV "in certain circumstances," however. There is no elaboration on these circumstances, other than the following statement: "For example, where the formula price is the current book value of stock, the book value of the stock at some time in the future may be a more accurate measure of the value of the stock than the current book value of the stock for purposes of determining the fair market value of the stock at the time the stock becomes substantially vested."

The regulations then provide an illustration that is helpful in understanding the intent of this provision. Reg. 1.83-5(c), Example 4, implies that this provision has the most applicability where the employee makes a Section 83(b) election. In the example, an independent contractor agrees to provide services in the construction of an office building in exchange for common stock. The stock is subject to a substantial risk of forfeiture until the services are completed. The contractor makes a Section 83(b) election. The stock is subject to a nonlapse restriction that uses book value.

In the example, there is outstanding preferred stock with a liquidation value. The liquidation value is so great that there is no remaining book value attributable to the common stock on the grant date. The example points out that the independent contractor must believe that the common stock has value; otherwise, he would not be willing to perform the services in exchange for the stock. Under these circumstances, according to the example, "[i]n determining the fair market value of the stock, the expected book value after construction of the office building would be given great weight." Thus, it is not always appropriate to simply apply the formula using values as of the measurement date.

Any restrictions that do not meet the relatively narrow definition of a nonlapse restriction are referred to in the regulations as a "lapse" restriction.[25] A lapse restriction is not taken into account in measuring the FMV of stock. Thus, a formula value that is to be used only for a limited period should not be considered in determining the stock's FMV.

There is no further help under Section 83 with respect to determining the FMV of stock. As in the determination of the grant date, the IRS has provided guidance on determining the FMV of stock in connection with incentive stock options under Section 421, as well as under Section 409A with respect to stock options and stock appreciation rights. Presumably, the IRS has chosen to provide the guidance under these sections due to the importance of accurately determining the FMV. Specifically, an option cannot qualify as an incentive stock option unless the exercise price is equal to or greater than the FMV of the stock on the grant date.[26] A stock option or stock appreciation right is subject to the restrictions on nonqualified deferred compensation plans under Section 409A if the exercise price is less than the FMV of the stock as of the grant date.[27]

The approach chosen by the IRS under these sections is to provide very general guidance, rather than to require the use of specific rules for determining FMV. The incentive stock option rules require only a "reasonable valuation method," and in a similar fashion, the nonqualified deferred compensation rules require only the "reasonable application of a reasonable valuation method."[28]

The incentive stock options regulations have little to say beyond the requirement that a reasonable valuation method must be used. In fact, the additional guidance is limited to a statement that majority or minority stockholder status may be taken into account, and that the valuation method described in the estate tax regulations is an example of a reasonable valuation method.[29] The estate tax regulations, in turn, list factors that must be taken into account in a valuation, such as the company's net worth, prospective earnings power, goodwill and the economic outlook of the industry.[30] In addressing whether a good faith attempt has been made to determine FMV, the regulations provide only one example, which is the determination of FMV based on an average of the FMVs determined by "independent and well-qualified experts."[31] Nevertheless, the averaging approach is simply an example of good faith; it is not a requirement.

In a fashion similar to the estate tax regulations, the regulations under Section 409A set forth factors that must be taken into account in determining FMV. These factors include the value of assets (both tangible and intangible), the present value of anticipated future cash flows, the market value of stock or equity interests in similar corporations or equity interests in similar corporations or other entities engaged in substantially similar trades or businesses. In addition, the valuation may reflect control premiums or discounts for lack of marketability. The valuation may be used for up to 12 months, but must be updated to reflect information that materially affects the value of the corporation, such as the resolution of litigation or the issuance of a patent.[32]

The Section 409A regulations go a step beyond any other guidance by providing safe harbor valuation methods. When one of these safe harbors is used in lieu of the general valuation approach, the valuation is presumed to be reasonable. The IRS may rebut the presumption only if the valuation is "grossly unreasonable.[33]

There are three safe harbor methods:

  • Appraisal by an independent party,[34]
  • Appraisal by a qualified individual who does not have to be independent (available only for "start-up" companies),[35] and
  • Formula value. [36]

Independent appraisal. The first safe harbor is largely self-explanatory. The regulations provide that in applying this safe harbor, the standards for the appraisal of stock held by an employee stock ownership plan under Section 401(a)(28)(C) and its accompanying regulations should be used. Section 401(a)(28)(C), however, simply states that the valuation must be performed by an independent appraiser, and the regulations provide no additional guidance. Thus, this safe harbor appears to rest solely on having an appraiser who is independent. The only additional guidance on this safe harbor is a requirement that in order for the valuation to be used, it must be as of a date within the past 12 months.

Non-independent appraisal. Under the second safe harbor, an appraisal is required, but the party performing the valuation need not be independent. The appraisal must take into account all of the factors described above in the discussion of general valuation principles. This safe harbor is available only for a corporation that has conducted its trade or business for less than ten years (a so-called "start-up" corporation). Thus, this safe harbor exists so that a newer corporation can avoid the cost of an independent appraisal.

The second safe harbor is not available if either the employer or employee reasonably anticipates that the corporation will undergo a change in control event in the next 90 days or an initial public offering within the next 180 days. The rationale for this appears to be that such events have the potential to cause a major change in the value of the corporation (most likely an upswing in value). In addition, this safe harbor may not be used if the stock is subject to any put, call or other right to purchase the stock, other than a right of first refusal upon an offer to purchase by an unrelated third party, or a non-permanent right to sell the stock or buy the stock at a formula value.

Although the individual who performs the valuation does not have to be independent, he or she must be qualified to perform the valuation. The individual's qualifications are based on his or her knowledge, experience, education or training. "Experience" generally means at least five years of relevant experience in valuations, financial accounting, investment banking, private equity, secured lending or other comparable experience in the line of business or industry in which the corporation operates.

Formula. The final safe harbor is the use of a formula value. At first, this may appear to be a very useful safe harbor, especially in light of the fact that many private companies have typically used a formula to determine FMV. In developing this safe harbor, however, the IRS looked to the principles adopted in the Section 83 regulations, because the safe harbor may be used only when the formula is a nonlapse restriction, defined in the same manner as under Section 83 (as discussed above). Thus, it is not intended to simply make the determination of FMV an easy task, as many private companies might hope. It is available only when the formula value is the value at which the stock must always be purchased and sold, and only when the formula applies to all parties on a permanent basis. The regulations provide one very notable exception to these otherwise relatively rigid conditions: The safe harbor may be used even though the formula value restriction is lifted in connection with the sale of all or substantially all of the outstanding stock of the corporation in an arm's-length transaction.

Public companies. As noted above, it is relatively easy for public companies to determine the FMV of their stock - it is the price at which its stock is traded. Nevertheless, it is not clear as to which particular transaction should be used to set the value. For example, should the value be determined based on the opening price on the grant date or the closing price on the grant date? As noted earlier, there is no detailed guidance under Section 83.

The regulations under Section 409A do provide detailed guidance on this issue, however, and set forth the range of alternatives acceptable to the IRS. Any practices that fall outside the parameters of this guidance might be of concern to the IRS, even with respect to compensatory practices that do not directly fall under Section 409A (such as the granting and vesting of restricted stock under Section 83). Thus, it is advisable for public companies to evaluate this guidance to determine whether their approach to determining FMV in connection with restricted stock may be acceptable to the IRS.

In reviewing this guidance, it is important to keep in mind that it relates to determining the exercise price of stock options, as well as determining the base price of stock appreciation rights. Thus, the methods for determining FMV all make reference to the grant date of the stock option or stock appreciation right. The regulations permit any of the following values to be used:

  • The price in a specific transaction, using either (1) the last sale before the grant or (2) the first sale after the grant;
  • The closing price on either (1) the trading day before the grant or (2) the trading day of the grant;
  • An average price (1) of the high and low prices on the trading day before the grant, (2) of the high and low prices on the trading day of the grant or (3) during a specified period that is within 30 days before or after the grant; or
  • A price derived using any other reasonable method using actual transactions.

Some of these alternatives are easier to apply to restricted stock than others. For example, the use of the closing price on the trading day before the grant or on the trading day of the grant works without difficulty in determining the stock's value on the grant date (i.e., when a Section 83(b) election is made). When a Section 83(b) election is not made, then the relevant date for measuring the FMV is the vesting date. Thus, the FMV could be determined as of the closing price on the trading day before vesting, or on the trading day that the stock vests. The "specific transaction" alternatives listed above also could be applied in a similar manner.

The "average price" alternative may not be appropriate, however. While it makes sense to set the exercise price of an option based on an average price (in order to minimize the effect on the exercise price of large increases or decreases in trading values), an average price does not seem appropriate for measuring the FMV of stock at a given point (i.e., on the grant date when a Section 83(b) election is made and otherwise on the vesting date).

Look for part 4 of 4 of this article in the next Buzz or read the entire article in chapter 7.1.2.a: Restricted stock: The Tax Impact On Employers and Employees of the Encyclopedia of Private Equity.

Eddie Adkins is Grant Thornton LLP's Compensation and Benefits Technical Practice Leader, based in the firm's National Tax Office in Washington, D.C. Previously, he spent 17 years at a Big 4 accounting firm, including 12 years as a partner. He has served as COO of a regional pension consulting firm and controller for a privately held company, as well as operated his own CPA firm. He serves on the AICPA Employee Benefits Technical Resource Panel. He received his Master of Accountancy from Virginia Tech.

Jeffrey A. Martin is a manager with the National Tax Office of Grant Thornton LLP located in Washington D.C., specializing in compensation and benefits. Since receiving his Masters in Professional Accountancy from West Virginia University, Jeff has spent the last four years with Grant Thornton practicing both federal taxation as well as compensation and benefits

Grant Thornton LLP is the U.S. member firm of Grant Thornton International, one of the six global accounting, tax and business advisory organizations. Through member firms in more than 110 countries, including 50 offices in the United States, the partners and employees of Grant Thornton member firms provide personalized attention and the highest quality service to public and private clients around the globe.

[1] Restricted stock also may be issued to compensate non-employees, such as independent contractors and directors. The tax treatment for non-employees generally is the same as for employees.

[2] APB 25, ô10.

[3] Large public employers were required to adopt SFAS 123(R) in the first quarter of fiscal years beginning after June 15, 2005. Small public employers (annual revenues or market capitalization less than $25 million) were required to adopt in the first quarter of fiscal years beginning after Dec. 15, 2005. Privately held employers were required to adopt in the first fiscal year beginning after Dec. 15, 2005.

[4] Some compensation planners argue that restricted stock is a less effective incentive for employees than stock options, because employees typically make no investment in the stock, and the stock has value to them even if the stock value goes down after the grant date.

[5] Section 83(c)(2).

[6] Reg. 1.83-3(b) states that property, e.g., stock, is "vested" when it is either transferable or not subject to a substantial risk of forfeiture. The term "vested" is commonly used in practice, however, in a manner that means simply that there is no substantial risk of forfeiture.

[7] Reg. 1.83-2(a).

[8] Id. See also Alves, 54 AFTR 2d 84-5281, 734 F2d 478 (CA-9, 1984), aff'g 79 TC 864 (1982).

[9] Reg. 1.83-2(e).

[10] See, e.g., Ltr. Ruls. 8452116 and 8833015.

[11] Section 83(b)(2).

[12] Reg. 1.83-2(f) and Rev. Proc. 2006-31, 2006-27 IRB 13.

[13] Reg. 1.83-3(c)(1).

[14] Reg. 1.83-3(c)(2).

[15] Reg. 1.83-3(c)(1).

[16] Reg. 1.83-3(c)(4), Example 1.

[17] Section 83(c)(3).

[18] Rev. Rul. 2005-28, 2005-19 IRB 997.

[19] Reg. 1.421-1(c)(1).

[20] Reg. 1.409A-1(b)(5)(vi)(B)(1). For more on these rules generally, see Hirsh and Schoonmaker, "Section 409A Final Regs. Provide Comprehensive Guidance for Post-Transition Period," 107 JTAX 150 (September 2007).

[21] Reg. 1.409A-1(b)(5)(vi)(B)(2).

[22] Reg. 1.83-5 contemplates the possibility that a restriction that was intended to be permanent may be cancelled in the future and provides that compensation income will arise as a result of the cancellation.

[23] Reg. 1.83-3(h).

[24] Reg. 1.83-5(a).

[25] Reg. 1.83-3(i).

[26] Section 422(b)(4).

[27] Reg. 1.409A-1(b)(5)(i)(A)(1).

[28] Regs. 1.421-1(e) and 1.409A-1(b)(5)(iv)(B)(1).

[29] Regs. 1.422-2(e)(2)(iii) and 1.421-1(e)(2).

[30] Reg. 20.2031-2.

[31] Reg. 1.422-2(e)(2)(iii).

[32] Reg. 1.409A-1(b)(5)(iv)(B)(1).

[33 ]Reg. 1.409A-1(b)(5)(iv)(B)(2).

[34] Reg. 1.409A-1(b)(5)(iv)(B)(2)(i).

[35] Reg. 1.409A-1(b)(5)(iv)(B)(2)(iii).

[36] Reg. 1.409A-1(b)(5)(iv)(B)(2)(ii).

[37] Reg. 1.83-1(f), Example 1.

[38] Rev. Rul. 83-22, 1983-1 CB 17; Rev. Proc. 83-38, 1983-1 CB 773.

[39] Rev. Rul. 79-305, 1979-2 CB 350.

[40] Reg. 31.3402(g)-1(a) defines supplemental wages to include "wage income recognized on the lapse of a restriction on restricted property transferred from an employer to an employee."

[41] Regs. 31.3402(g)-1(a)(2) and (a)(7)(iii)(F).

[42] Reg. 31.3402(g)-1(a)(2).

[43] Section 3101.

[44] Sections 3301 and 3302.

[45] The income tax liability on $1,000 of income at a 35% rate is $350. The gross-up calculation is as follows: $350 ž [1 ö (1 − .35)].

[46] Reg. 1.83-6(a)(2).

[47] Robinson, 92 AFTR 2d 2003-5349, 335 F3d 1365 (CA-F.C., 2003).

[48] Reg. 1.83-6(d).

[49] Notice 2007-49, 2007-25 IRB 1429. Due to the interaction between the statutory language of Section 162(m) and the recently changed SEC rules, the chief financial officer is not a covered employee.

[50] Section 162(m)(4)(C).

[51] Section 280G(b)(2).

[52] Section 280G(b)(5)(B).

[53] Sections 280G and 4999.

[54] Section 280G(b)(2)(A).

[55] Reg. 1.280G-1, Q&A-22(c) and -24(c)(1).

[56] Id., Q&A-24(c)(4).

[57] Id., Q&A-24(d)(3).

[58] Id., Q&A-12(b).

[59] Id., Q&A-27(a).

[60] Id., Q&A-28(a)(1). There are other circumstances under which a change in control may occur, but restricted stock has no impact on these circumstances.

[61] Rev. Rul. 2005-39, 2005-2 CB 1.

[62] Section 280G(c); Reg. 1.280G-1, Q&A-15 through -19.

[63] Rev. Rul. 2005-39, supra note 61.

[64] Sections 409A(a)(2), (a)(4), and (b).

[65] Section 409A(a)(1).

[66] Reg. 1.409A-1(b)(6).

[67] Reg. 1.409A-1(b)(6)(ii).

[68] Id.

[69] Sections 1361(b)(1)(A) and (D).

[70] Reg. 1.1361-1(b)(3). Stock existing on the effective date of the regulations (tax years beginning after May 27, 1992) that has been treated as outstanding by the corporation, even though it is substantially nonvested, continues to be treated as outstanding for purposes of Subchapter S. A history of issuing a Schedule K-1 with respect to the stock is evidence that the corporation has treated the nonvested stock as outstanding.

[71] Reg. 1.1361-1(l)(1).

[72] Reg. 1.1361-1(b)(3).