The following article is reprinted from The M&A Tax Report, Vol. 12, No. 1, August 2003, Panel Publishers, New York, NY.

STOCK OPTIONS VS. RESTRICTED STOCK: THE FOLLOWING MICROSOFT?

By Robert W. Wood

As if the news on the Treasury's attack on certain stock option arrangements was not enough (for related story, see Wood, "Executive Options? Not So Fast." this issue), a mere few days later, Microsoft grabbed worldwide headlines with its era-ending plan to eliminate stock options for employees. See Guth and Lublin, "Microsoft Ushers Out Era of Options," Wall Street Journal, July 9, 2003, p. A-1, and Waters and Morrison, "Microsoft Ends Employee Stock Option," Financial Times, July 9, 2003, p. 1. The news was attention grabbing in a couple of ways. Not only did it signal the end of the quintessentially high-tech golden age of options, and the flow of newly-minted employees/millionaires, but it also ushered in a transaction that will allow extant Microsoft option holders to transfer their options.

The big winner in the latter case (well, I suppose the employees will surely win something someday) is JP Morgan. Under the arrangement between JP Morgan and Microsoft, the latter will allow its employees to sell their options to JP Morgan for cash. JP Morgan will then hedge its exposure, thus making money on the spread between what it pays for the options and the amount they are ultimately worth. See Brown and Zuckerman, "JP Morgan's Deal with Microsoft Likely to Spur Many Firms," Wall Street Journal, July 10, 2003, p. C-1.

There are — get this — 1.6 billion (yes, that is billion with a B) options outstanding as of June 30, 2002. That makes Microsoft's deal with JP Morgan something to celebrate for the bank. Are others banks going to weep about this one? The answer is clearly No. In fact, many other banks and investment houses are already gearing up to find a way to expand the new Microsoft strategy. There are a plethora of other companies out there who also have many outstanding underwater stock options. Although the Microsoft options represent a big transaction, the prevalence of stock options in our culture makes the deal model — along with the inevitable cache of following what Microsoft does — quite neat.

The Wall Street Journal recently reported that between 7 and 10 million Americans have employee stock options. Id., citing the National Center for Employee Ownership. In the four years between 1998 and 2002, companies in the Standard & Poors 500 Stock Index gave their employees options valued at $157 billion at the time the options were issued. Technology companies accounted for 41% of that total, according to UBS. Id.

A good deal is being said, of course, about the long-term (and even the short-term) effects of all this. Will there be a major effect in how companies acquire and keep people? Will it be different in the traditionally equity incentivised high-tech world? Not surprisingly, Microsoft (and other companies who will likely go the same route) are already saying that employee will be way better off under this new system. Microsoft CEO Steve Ballmer described in an interview how employees would be much better off with restricted stock. See "Ballmer Seeks Stability in Stock Awards," Wall Street Journal, July 10, 2003, p. B-1. Still, cultures will likely be changing. See Guth, "Cultural Evolution," Wall Street Journal, July 10, 2003, p. B-1.

Back to Basics

With all this hyperbole, it may seem surprisingly that the basics of restricted stock haven't changed very much over the years. With a few quirks about stock aside, this whole area is governed by basic concepts about constructive receipt, risk of forfeiture, and the like. An employee will not be taxable on stock (or other property) received that is subject to a substantial risk of forfeiture. Under the typical arrangement, an employee is awarded stock in the company subject to a condition that the stock will be transferred back to the company in the event certain specified conditions occur. For example, if the employee leaves the company for any reason within a specified period, the employee would be required to transfer it back.

Section 83 sets out the circumstances under which stock will be considered subject to a substantial risk of forfeiture. Some restrictions are known as "lapse restrictions," and some as "non-lapse restrictions." Only the former are relevant in accessing whether the employee should be currently taxed on the items. Non-lapse restrictions (which, by their terms, will never lapse) are not relevant.

Whether a risk of forfeiture is considered substantial (thus preventing current tax) depends on the facts. The regulations say that a substantial risk of forfeiture exists where the rights and the property transferred are conditioned, directly or indirectly, upon the future performance of substantial services by any person, or upon the occurrence of a condition relating to the purpose of the transfer, and where the possibility of forfeiture is substantial if such a condition is not satisfied. See Reg. Section 1.83-3(c)(1).

What about some examples? A requirement that an employee return stock in the event he is discharged for committing a crime or for cause, is not considered to represent a substantial risk of forfeiture. However, a requirement that the employee return the shares if the employee leaves for any reason (in other words, resignation or discharge without cause) is typically considered substantial. A non-compete agreement may (but ordinarily will not) be considered as imposing a substantial risk of forfeiture. Factors considered in accessing a covenant not to compete include the employee's age, the availability of alternative employment, the likelihood the employee might obtain other employment, the degree of the employee's skill, etc. The employers' historical practice in enforcing such covenants can also be relevant.

A substantial risk of forfeiture is considered to exist as long as the sale of the securities at a profit could subject the recipient to liability under Section 16(b) of the Securities Exchange Act of 1934. Section 16(b) (the so-called "short swing of profits" provision) provides for recapture of gain resulting from a purchase and sale with six months of equity securities of a publicly traded employer. This provision applies to officers, directors, and 10% shareholders.

The 83(b) Election

Up to now, you would think that a substantial risk of forfeiture is — at least from a tax perspective — a good thing. It prevents the employee from being taxed until those substantial restrictions lapse. However, sometimes (in fact frequently) an employee receiving restricted stock may want to elect to include the value of that stock in income notwithstanding the restrictions. When does anyone elect to pay tax earlier than the government would normally impose it? Predictably, the answer lies in advantages that will accrue later.

Despite the rule that stock is not taxable to the employee until it is no longer subject to a substantial risk of forfeiture, Section 83(b) allows an election by the employee to include the value of the stock in income now. The election must be filed within thirty days of the transfer, and a copy is later attached to the employee's return. Valuation, of course, can be debated.

Putting that issue aside, the advantage of making the election is that any difference between the value at the time of receipt of the stock (the value included in income under the Section 83(b) election) and the ultimate sales price when the employee actually disposes of the stock, will be treated as a capital gain. In contrast, if no Section 83(b) election had been filed, the employee would pay income tax at ordinary income rates on the value of the property when the restrictions lapse (not necessarily when the property is disposed of). There is therefore both an important timing difference which the 83(b) election affects, and also a tax rate differential.

The following table illustrates the radical shift which the 83(b) election affects.

Transfer of Property Subject to Substantial Restrictions

	Without Section 83(b) Election	With Section 83(b) Election
Taxable on initial transfer?	No	Yes (as ordinary income)
Taxable when restrictions lapse?	Yes (as ordinary income)	No (the lapsing of restrictions becomes a non-event)
Taxable on sale or disposition of property?	Yes (only on appreciation between time restrictions lapse and time of disposition, as a capital gain)	Yes (only on appreciation between initial transfer and time of disposition, as a capital gain)

There has been a considerable amount of confusion over the years about 83(b) elections. It is important to recognize that the rules of Section 83 may apply even where the employee purchases the stock or other property from the employer. After all, the purchase may be at a bargain price, in which it is clear that the stock is being transferred in connection with the performance of services. Moreover, even if the employee pays full value for the stock (such as founder's shares in a company in which the shares are not commercially available), Section 83 still applies. That may seem unfair, but this rule well-established, and sometimes can represent a real trap. The leading case on this subject is Alves v. Commissioner, 734 F.2d 478 (9th Cir. 1984).

As a result, where an employee pays market value for the stock, it is clearly appropriate for the employee to file an 83(b) election. That way, when the restrictions do lapse, the full value of the shares will not be taxable at that moment. After all, a Section 83(b) election can be filed reporting zero income. That is perfectly appropriate where the market value for the shares was the price paid. A zero income 83(b) election will protect future appreciation in the shares, and will defer the event of taxation from the lapse of the restrictions to the actual date of disposition of the shares by the employee.

Critical Timing

A word about mechanics. The Section 83(b) election is not made on a pre-printed form. Still, most tax advisors have a form they have worked out that is only a page or two. Predictably, the key elements are identifying the stock (or other property) transferred, making plain the election, and reporting the value. There is a premium on timing, since the election must be filed within thirty days of the receipt of the property. Another copy of the 83(b) election is filed with the taxpayer's return for the year of receipt.

What happens to the 83(b) elections within the Service? I'm not sure. Not only have I never had an 83(b) election queried by the Service in 24 years, but I have never heard of anyone else who has. While this is hardly a statistical sampling, I suspect that 83(b) elections are rarely reviewed.

That may lead at least some taxpayers (if not their advisors) to wonder just how important the timing requirement is. The Code is quite clear when the election must be made, so a late Section 83(b) election would probably just not work. I will admit I've never tried this, nor heard of anyone else who has, but I am suspicious that someday we will see a case dealing with a taxpayer who fails to timely file the election within 30 days of the receipt of the restricted property, but does manage to file the election with a copy of his tax return. Regrettably, I think the courts will say "too bad" to the taxpayer. Again, with what I project as the increasing importance of restricted stock plans, these ancillary practical issues are likely to become more important as well.

Conclusion

Restricted stock plans are likely to be at the forefront of many companies' minds. After the feeding frenzy over the type of plan conversion and repurchase arrangement for the options upon which Microsoft has embarked, even more garden variety restricted stock plans will likely be adopted with considerable fervor. Given that restricted stock plans will clearly become more prevalent in the future than they were in the past, we can expect new authorities dealing with the sometimes fuzzy line between substantial (and insubstantial) risks of forfeiture.

Stock Options vs. Restricted Stock: The Following Microsoft?, Vol. 12, No. 1, The M&A Tax Report (August 2003), p. 5.