Probate & Trust Law Section Conference Manual ... - Minnesota CLE

The Well-Prepared Executive: Personal Wealth Preservation Strategies
provisions. Thus, if the IRS took the position that a
constructive exchange took place, the taxable event
is the time of the constructive exchange.
Presumably, the value of the unrestricted shares is at
least equal to the restricted shares. Thus, the
founder or senior executive would recognize no
income upon making the protective IRC § 83(b)
election. Moreover, under IRC § 1036, no gain
would be recognized on any appreciation in the
unrestricted shares deemed exchanged for the
restricted shares. Any future appreciation in the
stock would be taxed as capital gains when sold. It
now appears that the IRS will not take the position
that a subsequent imposition of vesting constitutes a
“transfer” under IRC § 83. In PLR 200204005, the
IRS ruled that placing vesting provisions on LLC
interests already owned does not constitute a
transfer under IRC § 83.
C. Summary of Restricted Stock Advantages
1. Substantial tax benefits to the executive if
the restricted stock is issued when the value is low.
The executive can make the IRC § 83(b) election
and thereby preserve capital gains treatment on all
future appreciation in the value of the stock. Thus,
restricted stock plans are especially popular for
founders and other senior executives in start-up
companies.
2. Gives the executive an immediate
ownership interest in company (psychic satisfaction
of being an “owner”).
D. Summary of Restricted Stock
Disadvantages
1. Potential for substantial phantom ordinary
income. If the stock value is high when the
restricted stock grant is issued, the executive likely
would not make the IRC § 83(b) election. Instead,
the executive would be taxed when the stock
became vested, potentially resulting in substantial
phantom ordinary income if the executive cannot
immediately sell a portion of the stock. Thus,
restricted stock plans are usually not a viable choice
for private companies with substantial current value,
unless the company expects to be public when the
restricted stock becomes vested and the executive
would be able to sell portion of his stock to avoid
phantom income.
2. An executive’s immediate ownership at less
than fair market value may not provide as much
incentive for the executive to work to increase the
value of the company (since the executive has
3
received an immediate benefit regardless of the
subsequent increase in the company’s value).
3. Shareholders (including executives who are
shareholders) have certain state law rights such as
right to:
a. Receive notice of meetings;
b. Inspect company’s books and
records; and
c. Hold the company and its
controlling shareholders accountable for fiduciary
duties.
4. Issuance of restricted stock to executives
may make the employer less attractive to venture
capitalists or other financiers who do not wish to see
such dilution without a corresponding cash inflow at
the stock’s fair market value.
III.
STOCK OPTION PLANS
A. Description
Stock options are the most common equity
compensation plan. A stock option is a right to buy
stock at the exercise price at some point in the
future. The exercise of a stock option is typically
subject to vesting provisions. Generally, unvested
options are forfeited upon the executive’s
termination or resignation. There are two types of
stock options: incentive stock options (“ISOs”) and
nonqualified stock options (“NQOs”). ISOs are
options that provide employees favorable tax
consequences under IRC § 421. ISOs must meet the
rigid requirements set forth in IRC § 422. Any
option that does not meet the ISO requirements is an
NQO.
B. Incentive Stock Options
1.
Executive’s Income Tax Consequences
a. Grant
No tax to the executive upon the grant of an
ISO. IRC § 421(a).
b. Exercise
No tax to the executive upon the exercise of
an ISO, except may be subject to alternative
minimum tax (“AMT”) as discussed below. IRC §
421(a). An executive exercises an ISO by
purchasing the stock at the exercise price stated in
the grant.