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Who's the Employer?

Answers are provided by S. Derrin Watson, JD, APM

Restricted Stock and HCEs

(Posted March 26, 2001)

Question 91: My company has issued restricted stock to several employees. They bought the stock at fair market value, but have to stay with the company four years to be fully vested. If the employee leaves the company before four years, the company can buy back the unvested stock at the same price the employee paid. Until then the employees have all the normal rights of a shareholder, including the power to vote and receive dividends. How is this stock counted for purposes of determining who is a 5-percent owner and thus a highly compensated employee and a key employee?

Answer: Ownership for purposes of the HCE and key employee rules is defined in Code section 416(i)(1)(B)(i)(I), which defines a 5-percent owner as:

Any person who owns (or is considered as owning within the meaning of section 318) more than 5 percent of the outstanding stock of the corporation or stock possessing more than 5 percent of the total combined voting power of all stock of the corporation. . .

Neither in section 416, nor in the attribution rules (section 318) is there a reference to disregarding restricted stock. Contrast this with the controlled group rules of sectopm 1563, which expressly allow you to ignore certain restricted stock if doing so would create a controlled group. There is no such provision here.

So the employees own what stock they own, whether it is vested or not. The fact that they might have to sell it later does not take away from their current ownership, nor does it cause the stock to be treated as though it hadn't been issued.

As far as attribution rules go, the only one that would be particularly relevant here is that a person who has an option to buy stock is deemed to own the stock. The question is whether this restriction is equivalent to an option on the part of the corporation. Offhand, I'd say no. The fact that an employee has to leave (voluntarily or involuntarily) before they have the repurchase right makes that right subject to a significant condition precedent, which in my mind negates the presence of an option.

The attribution rules applicable to highly compensated employees are discussed in greater detail in Chapter 14 of my book, Who's the Employer?.

Important notice:

Answers are provided as general guidance on the subjects covered in the question and are not provided as legal advice to the questioner or to readers. Any legal issues should be reviewed by your legal counsel to apply the law to the particular facts of this and similar situations.

The law in this area changes frequently. Answers are believed to be correct as of the posting dates shown. The completeness or accuracy of a particular answer may be affected by changes in the law (statutes, regulations, rulings, court decisions, etc.) that occur after the date on which a particular Q&A is posted.