Glen Head, NY

Why would any employee want to refuse a bonus in stock? Well, that would depend. What would the tax effect be to him on the receipt of the stock? How much value would the stock have for tax purposes? Where would the cash to pay the tax come from? Could any of the stock be sold to raise the cash to pay the tax? And if the stock couldn't be sold now, when could it be sold and what if the stock loses value by then?

Well, as to the tax effect, §83 provides that if, in connection with the performance of services, property is transferred to any person, the fair market value of such property shall be included in the gross income of the person who performed such services (unless the stock was subject to a substantial risk of forfeiture).

That section provides that the fair market value of such property is determined without regard to any restriction other than a restriction which by its terms will never lapse. That means that if the stock is stock of a public company but the stock is not registered stock and so cannot be sold on the open market or if the stock is subject to an agreement that it cannot or will not be sold for a period of time, it must be valued as if the restriction was not in effect. (There is an exception for sales which may give rise to suit under §16(b) of the Securities Act of 1934 which treats the rights in such property as subject to a substantial risk of forfeiture and postpones the taxability until the 16(b) time--six months--has passed.)

If the stock is in a non-public company, perhaps a “start-up” company, then Regs. §20.2031-2(f)(2) provides that the company's net worth, prospective earning power and dividend-paying capacity, and other relevant factors must be used to determine the value of the shares. Some of the “other relevant factors” would be the good will of the business; the economic outlook in the particular industry; the company's position in the industry and its management; the degree of control of the business represented by the block of stock to be valued; and the values of securities of corporations engaged in the same or similar lines of business which are listed on a stock exchange. Such a valuation is not easily made and may be challenged by the IRS.

And what is the benefit of owning a minority interest is a non public company unless the company pays dividends or will soon be sold or go public? And it's worse if the corporation has elected to be an S corporation where earnings are taxed to shareholders--every year--unless there is an assurance that dividends can and will be paid to cover those taxes--again every year.

And, then, even after a valuation of the non public stock is determined, the stock may be subject to a sales restriction agreement and any sale at any price may be prohibited.

This means that even if none of the stock (whether public or not public stock) can be sold because of restrictions on its sale, for purposes of determining how much income is realized on its receipt, it will be valued as if there were no such restrictions.

Cash, therefore, for the taxes would have to come from the employee's personal funds.

And, if at a later date, things don't work out as planned and the stock declines in value then: (1) there is no relief until such time as the stock is sold; and (2) when the stock is sold the employee will have only a capital loss measured by the difference between what he then receives for his stock and the amount he previously had to consider as income (which then had become his basis.)

There is a way for the employer to help the employee with this dilemma.

As the employee will have taxable income on the receipt of the bonus stock, so too will the employer receive a tax deduction for compensation expense (assuming, of course, that the employer is profitable and pays taxes). The employer could “share” some or all of the savings from that tax deduction with the employee as an additional bonus (and that bonus will be taxable and deductible as well--subject to it being considered “reasonable compensation etc.)

Let us say that both the employer and the employee are in a 35% income bracket and the fair market value of the stock given as a bonus to the employee is $100,000. Let us further assume that the employer will pay a cash bonus to the employee that will: (1) cover the tax to the employee on the stock AND the bonus; and (2) not cost any loss of cash to the employer.

Using a formula to compute the bonus, we can let “X” be the unknown amount to be determined.

Therefore, in our example:

X = 35% ($100,000 + X)

X = 35% $100,000 + 35% X

65% X = $35,000

X = $53,846.

(To test the result--The employee receives compensation (stock and cash) of $153,846 and the tax on that at 35% is the cash bonus or $53,846. The employer pays out the stock and the cash together valued at $153,846 and saves taxes at 35% or $53,846, the amount of the cash given.)

(Of course both the employer and the employee should use the same value for the stock.)

Of course, the employer need not cover ALL the employee's taxes on the bonus and may want to pick up SOME of the employee's burden and, at the same time, secure a tax saving for itself

For more information, in the Tax Management Portfolios, see Bosley and Hutzelman, 370 T.M., Qualified Plans -- Taxation of Distributions, and in Tax Practice Series, see ¶5550, Tax Aspects of Qualified Retirement Plans.