Letter Ruling Reaffirms the Use of Restricted Stock by S Corporations

Although the use of restricted stock is a common component of the overall compensation strategy of most publicly traded C corporations, several issues arise when a closely held S corporation grants restricted stock to its employees. In Letter Ruling 200118046, the IRS determined that an S corporation's issuance of nonvoting common stock to key employees and the payment of bonuses to those employees would not cause it to have more than one class of stock.

The founders of an S corporation wanted to transfer nonvoting stock in the corporation to certain key employees. The stock grants were to vest at future specified dates, conditioned on the employees' continued employment by the corporation on the vesting date. The employees were required to execute an agreement that the stock's fair market value (FMV) was to be its book value. The agreement further required the key employees to offer their stock to the corporation and its shareholders at book value when the key employee's employment terminated or there was an attempted voluntary or involuntary transfer of the stock.

During the vesting period, the corporation was required to pay the key employees, annually and in arrears, bonuses equal to a percentage of the distributions paid to the founders with respect to their stock. The bonuses were to be treated as wages subject to withholding and deductible by the corporation. In addition, a key employee whose employment terminated during the vesting period was entitled to a payment equal to certain book appreciation in his respective restricted stock during the vesting period.

The ruling contains four characteristics common to S corporation restricted-stock programs:

1. The use of nonvoting stock to make grants to employees;

2. The existence of a buy-sell agreement requiring stock to be returned to the corporation or its shareholders or both on termination of employment;

3. The use of book value as an agreed-on FMV; and

4. The payment of "dividends" on the restricted stock during the vesting period.

In addition, to the extent employees are entitled to severance equal to certain book appreciation in their respective restricted stock shares, the fact pattern incorporated a modified stock appreciation right (SAR) plan.

Use of Nonvoting Stock and Existence of Buy-Sell Agreements

Sec. 1361(b)(1)(D) provides that an S corporation may not have more than one class of stock. This requirement can present several potential difficulties to closely held corporations that are considering granting restricted stock to employees. Although they may be willing to share the company's financial success with employees in the form of stock ownership, existing shareholders may be reluctant to share voting control. In addition, they may want to restrict the employee's ability to transfer stock to outside parties and may even want the employee to be required to sell the stock back to the corporation or its shareholders when his employment with the corporation terminates. At the same time, however, existing shareholders typically do not wish such limits to apply to their stock.

Fortunately, differences in voting rights among shares of an S corporation's stock are disregarded in determining whether a corporation has more than one class of stock (Sec. 1361(c)(4)). Although Regs. Sec. 1.1361-1(l)(1) requires all outstanding shares of stock to confer identical rights to distribution and liquidation proceeds, buy-sell agreements among shareholders, agreements restricting the transferability of stock and redemption agreements generally are disregarded in determining whether a corporation's outstanding stock confers identical distribution and liquidation rights, unless a principal purpose of the agreement is to circumvent the one-class-of-stock requirement of Sec. 1361(b)(1)(D) and the agreement establishes a purchase price that, at the time the agreement is entered into, is significantly in excess of (or below) its FMV (Regs. Sec. 1.1361-1(l)(2)(iii)(A)).

Book Value as FMV

Because there are no quoted market prices for closely held corporations, valuation poses a unique difficulty in the administration of their equity compensation plans. Valuation is important, because it determines the amount to be included in income by the employee and deductible by the corporation when the restricted stock vests or when a Sec. 83(b) election is made. Valuation is also important when a buy-sell agreement requires an employee to sell his stock to the corporation or its shareholders. In addition, when the corporation is an S corporation, there is the additional risk that the use of a non-FMV could be recharacterized by the Service as creating nonuniform liquidation rights that violate the one-class-of-stock requirement, thereby causing the corporation to lose its S status.

To minimize potential controversies that may arise, equity compensation plans should specify how value will be determined. Most plans incorporate one of the following three valuation methods: (1) a formula-based price (e.g., book value); (2) outside appraisal; (3) determination by the board of directors. Although a formula-based value is not always appropriate, it avoids the cost of appraisals and is generally perceived as being fairer than a value determined at the discretion of the board of directors.

In determining whether the valuation methodology creates nonuniform liquidation rights that violate the one-class-of-stock requirement, a determination of book value will be respected if it is determined in accordance with generally accepted accounting principles (including permitted adjustments) or if book value is used for a substantial nontax purpose (Regs. Sec. 1.1361-1(l)(2)(iii)(c)). A formula price based on book value will also ordinarily be regarded as determinative of FMV for Sec. 83 purposes (Regs. Sec. 1.83-5(a)).

Dividends on Restricted Stock

For purposes of subchapter S, stock issued in connection with the performance of services (within the meaning of Regs. Sec. 1.83-3(f)) and substantially nonvested (within the meaning of Regs. Sec. 1.83-3(b)) is not treated as outstanding stock of the corporation, and the holder of such stock is not treated as a shareholder solely by reason of holding it (Regs. Sec. 1361-1(b)(3)). Thus, the restricted stock recipient generally is not allocated corporate income or loss. Nonetheless, it is an established practice to pay dividends on restricted stock before the recipient of the restricted stock is treated as the owner of the stock for tax purposes. Such payments generally are treated as bonuses, taxable to the employee and deductible to the corporation.

This creates a unique problem to the S corporation that wants to grant restricted stock to its employees. Because S shareholders often use dividends from the S corporation as the source of cashflow to pay their personal tax liability attributable to the S corporation, closely held S corporations may pay substantial dividends. Unless the corporation reduces the "dividend" rights on the restricted stock, a potential inequity may exist; the holders of restricted stock will receive significant cash bonuses without the corresponding tax burden. To remedy this potential inequity, the corporation may modify (or perhaps even eliminate) the right of the holders of restricted stock to receive dividends.

If, however, an employee who has received restricted stock makes a Sec. 83(b) election to include an amount in gross income in the year of transfer, the stock is treated as outstanding stock of the corporation. Before making a Sec. 83(b) election, it is necessary to determine whether the election will cause the S election to terminate due to a second class of stock or because the corporation will have an ineligible shareholder or more than 75 shareholders. In addition, it is necessary to determine whether it is advantageous for the corporation's income or loss to be allocated to the holders of the restricted stock for tax purposes.

Example: X is an S corporation wholly owned by A. The corporation grants 50% ownership to its key employee, B, in the form of restricted stock. X’s income (before any deduction for bonuses attributable to restricted stock dividends) is $100. The corporation has a policy of paying annual dividends equal to 40% of income, to provide A with the cash necessary to pay his personal tax liability. The corporation has agreed that, during the vesting period, B will be entitled to receive “dividends” on his restricted stock equal to the amount of dividends paid to A.

The table compares the differences in A’s and B’s treatment during the restricted stock vesting period assuming that B (1) makes a Sec. 83(b) election and is treated as owner of the restricted stock and (2) does not make a Sec. 83(b) election and A is treated as owner of the restricted stock.

As shown in the example, when B is treated as owner of the restricted stock, A and B each receive a $20 dividend, intended to enable each to pay his tax liability attributable to X's income. If, however, A is treated as the owner of stock, A receives a dividend of $28.57 and B receives a bonus of $28.57 (which is deductible by the corporation).

Book Appreciation Payment on Termination

The final issue in Letter Ruling 200118046 was the tax treatment of the modified SAR feature of the plan. From a tax perspective, the primary risk in designing an SAR is constructive receipt; the recipient of the SAR will be required to include the appreciation in income as soon as it occurs.

An item of gross income generally is constructively received by a taxpayer and must be included in gross income in the tax year in which it is credited to the taxpayer's account, set apart or otherwise made available, so that the taxpayer may draw on it at any time; however, income is not constructively received if the taxpayer's control of its receipt is subject to substantial limits or restrictions (Regs. Sec. 1.451-2(a)). In Rev. Rul. 80-300, the IRS held that an employee possessing SARs was not in constructive receipt of income by virtue of the appreciation of the employer's stock, because the employee's right to benefit further from appreciation of stock without risking any capital is a valuable right, the forfeiture or surrender of which is a sufficient restriction to preclude the application of constructive receipt.

Citing Rev. Rul. 80-300, Letter Ruling 200118046 concluded that the mere contractual right of a key employee to a severance payment equal to the book appreciation of the restricted stock on termination without cause will not result in taxable income on termination without cause.

From Natalie Bell, CPA, MT, Cohen & Company, LTD, Cleveland, OH