Restricted Stock: Grossing Up

Joseph W. Bartlett, Special Counsel, McCarter & English LLP, Co-Founder of VCExperts

McCarter & English LLP

2002-08-02

Restricted stock is stock issued outright to an employee in a taxable transaction. If the stock is subject to vesting, a substantial risk of forfeiture, the employee may postpone the tax, ordinary income, until the vesting period expires. Most do not. They pay tax currently, on issuance, which often is set at a low price in the case of a start-up, making the election under Section 83 (b) of the Code and then paying tax on the gain when the shares are sold at capital gains rates. An employee may be issued stock at bargain prices (or for free), plus a cash bonus in an amount sufficient to allow the employee to pay tax on the bargain purchase element. This is a relatively simple transaction called "grossing up." The result is that the employee gets the stock, after all taxes are paid, at the bargain price he agreed to pay and the employer, since it is paying the employee in cash, has a pot from which to withhold and, accordingly, take the deduction. The problem is that "grossing up" costs the company money at a time when cash may be scarce and it debits earnings when every drop of reported income may be precious in valuing the company's stock.