Both emerging and established companies award equity, often in the form of stock options or restricted stock (or restricted stock units), to service providers. Equity awards can be a means to provide both compensation and incentives which are aligned with increasing the company’s value.

Stock options v. Restricted stock

Many tax and nontax considerations affect the choice between options and restricted stock. Notable considerations include the following:

– Dilution to existing shareholders. Subject to vesting conditions, restricted stock may have value on the date of grant which accrues to the holder, whereas that value does not accrue to the holder of a stock option, because the option holder pays an exercise price no less than the stock value on date of option grant. As a result, a lesser (i.e., less dilutive) quantity of restricted stock can be issued to a service provider as compared to stock options to produce the same amount of compensation to the recipient.

– Impact of (mis-)valuation. Restricted stock, by virtue of the fact that the stock compensation is treated as received upon vesting (or is treated as received at grant if a section 83(b) election is made), is typically not subject to section 409A of the Internal Revenue Code which restricts the ability of service providers to receive deferred compensation and imposes a 20 percent penalty (plus interest) in the event of deferred compensation that runs afoul of its myriad rules. In comparison, while stock options with exercise price no less than fair market value of the stock at time of option grant will also be outside section 409A, if it were later determined that the exercise price is less than the value of stock at option grant, then the option recipient can be subject to the section 409A penalties.

– Ordinary income versus capital gain. A “section 83(b) election” can be made for restricted stock to treat the stock as received on the grant date. The consequence of a section 83(b) election is that the value of the stock at time of grant (less any amount paid to acquire the restricted stock) is ordinary income to the recipient, but upon a later disposition any post-grant appreciation in the stock is taxed as capital gain. By contrast, when a recipient of a nonqualified stock option (i.e., other than a statutory “incentive stock option” or “ISO” which has its own rules and limitations) exercises the option, he or she recognizes ordinary income equal to the stock’s fair market value at time of exercise less the exercise price. Given the diverging ordinary income and capital gain tax rates, the above difference in income character upon disposition of restricted stock for which a section 83(b) election has been made, on the one hand, and upon exercise of a nonqualified stock option, on the other hand, can be significant. (On the flip side, a section 83(b) election on restricted stock does carry a risk to the recipient that if the stock were to be forfeited, the forfeiture results in a capital loss which may not fully offset the ordinary income recognized earlier upon the section 83(b) election.)

Restricted stock units

Some employers may prefer to award incentive compensation under a restricted stock unit (“RSU”) plan, under which stock (or equivalent cash if cash-settled) is delivered only when vesting conditions are satisfied. Since no stock is issued before vesting, there is no occasion to make a section 83(b) election. This may make administration (timing of employee tax withholding and employer deduction) simpler for the employer, although employers do need to keep in mind section 409A implications of the timing of award payments upon vesting.