The Advisors' Blog

– Broc Romanek, CompensationStandards.com

A number of members emailed me some of their reactions to Peter Hursh’s recent blog about restricted stock. Below I repeat Peter’s four thoughts (which I have italicized) followed by reactions sent to me – and then that is followed by further thoughts from Peter:

1. Restricted stock gets capital gains treatment, either from the date of the 83(b) election, however infrequent, or from the date of vesting. RSUs never get capital gains treatment; they are always subject to ordinary income tax. For most executives, the federal capital gains tax is 15% through 2010, and then 20%. The highest marginal federal income tax rate is 35%.

Reactions from members:

– This is true from the executive’s viewpoint but neglects to point out that the employer correspondingly gets a lower deduction to the extent the executive realizes capital gain and while this may or may not affect the size of the award it should clearly be known and considered by the committee.

– Both restricted stock and RSUs are taxed as ordinary income, restricted stock when the vesting restrictions lapse and RSUs when paid, which of course can be structured to be when the restrictions lapse. If RSUs are paid in stock, which is typical, they will also be subject to capital gains treatment.

Peter’s further thoughts:

The point is that the executive gets capital gains treatment while holding the stock, on all gains that occur after the restrictions lapse- – hence the words in my point 4: “locking in capital gains treatment from the date of grant.” The executive can never get capital gains treatment while holding the RSU’s. And, since RSU’s are typically held until termination of employment, ordinary income tax applies the entire time the RSU’s are in effect.

Regarding the last thought of this comment – “If RSUs are paid in stock, which is typical, they will also be subject to capital gains treatment” – my reply is: “Yes, but only the stock gains that occur after the individual receives the stock are subject to capital gains tax. Although RSU’s can be designed to pay out before termination of employment, they seldom are.”

2. Restricted shares are protected from creditors in bankruptcy. RSUs, which are nothing more than deferred compensation that tracks the performance of the company’s stock, are not protected from creditors in bankruptcy.

Reactions from members:

– This a particularly confusing comment since while it is true that the settlement obligation reflected by RSUs are not protected from the claims of creditors in the event of the employer’s bankruptcy, the creditor status claim of the RSU holder will come ahead of the equity status claim of the restricted stockholder.

– If a company goes bankrupt, I agree that the restricted stock is not subject to the claims of creditors, but the stock is worthless anyway.

Peter’s further thoughts:

On the last point, I agree but that’s assuming the executive still owns the stock. The executive could have sold the stock while still employed, while he or she probably has the RSU’s until termination of employment. That is, long before any signs of bankruptcy, the executive could have sold the stock sometime after the restrictions lapsed and the stock went up in price, so that he or she cashed in at the more favorable capital gains tax rate.

3. The recipient of restricted stock has the flexibility to sell his or her shares, once vested, even while he or she continues to be employed by the company or serve as a director. RSUs are often not available to cash-in until the individual terminates employment with the company.

Reactions from members:

– In many, many cases pre-409A and I suspect in even more cases post-409A RSUs will settle upon vesting thereby permitting the shares to be sold so the difference this comment is based on will not be as prevalent as the comment would lead the reader to believe.

– RSUs can be designed to work exactly like restricted stock–he is criticizing the vehicle assuming a certain design.

Peter’s further thoughts:

Most RSU’s are designed to be held until termination of employment, especially under the new and complex rules on deferred compensation.

4. The section 83(b) election should not be dismissed out of hand. The executive who truly believes in his or her company will make the election, locking in capital gains treatment from the date of grant. If the executive thinks that the stock price will go through the roof, then he or she can be a big winner. Moreover, the election sends a very strong message to shareholders abut the alignment of the executive’s interests with theirs.

Reactions from members:

– Section 83(b) elections are very rare. If an executive leaves the company during the restriction period, the stock is forfeited even though taxes have been paid. There aren’t a lot of executives who want to take on that risk.

– By the way, the dividends and voting rights on restricted stock do not have to commence on the date of grant. The dividends can be held until vesting occurs, and the voting rights can be barred until vesting.

Peter’s further thoughts:

The person responding is “criticizing the vehicle assuming a certain set of facts,” to borrow the words above. Yes, there is that risk of forfeiture – but only if the executive leaves voluntarily without “good reason” or is fired for “cause,” neither of which happens very often at all, and both of which are minimal risks from the executive’s standpoint.