Stock options and stock incentive programs are usually associated with huge publicly traded companies. But many small businesses recognize the value of stock incentive plans for retaining good employees. Traditionally, the vehicle used is stock options. The employee gets a double incentive: 1) Stay with the company long enough to be able to exercise the option and 2) work hard to improve the value of the stock so your option becomes profitable.

But stock options have certain disadvantages. If the value of the stock drops over time to a level below the strike price, then the employee has a worthless document. The other disadvantage is that the employee receives no dividend payments prior to exercising the option, reducing the perceived benefit. Because of these “disincentives”, it is often necessary to give away stock options in large numbers in order to deliver the “benefit” that the employee is seeking.

A new alternative is surfacing. Actually, restricted stock has been around for years. But Microsoft® recently issued restricted stock in place of stock options, and caught the interest of the marketplace in doing so. Restricted stock is different from an option because you actually give the employee stock today. The stock is restricted in that it cannot be sold. Also, there is a vesting period. If the employee leaves prior to vesting, she forfeits the stock. But because the employee owns stock today, the employee is entitled to dividends today. The employee also never needs to raise capital to purchase stock in order to exercise the option. Finally, the employee wins even if the stock value drops. With a $10 option, there is no benefit if the stock price drops below $10. But with restricted stock, an employee receiving stock worth $10 initially still gets a benefit even if the price later drops to $8 (because the employee paid nothing for the stock.) The bottom line is that the employer can issue fewer shares because each share carries more perceived (and actual) value. This reduces the dilution that comes along with a huge issuance of options, and eliminates the unpredictability of wonder who will exercise their options and when.

There are a couple of ways to issue restricted stock. Standard restricted stock is handed to the employee today, and starts paying dividends immediately. The employee claims the full value of the stock as ordinary income only when it vests, and claims dividend income as dividends are received. The employee can also make a special Section 83(b) election to recognize the income immediately. This is usually done if the value of the stock is expected to increase. That way, the value of the stock is taxed as income today, and any future increase in value is taxed at the lower capital gains rate. One advantage under this scenario is that the employer could take a current deduction for the income provided to the client, instead of waiting until the vesting period had ended.

The other option is to issue restricted stock units. Instead of giving stock to the employee today, the stock is held by the employer during the vesting period, and is given to the employee once the vesting period ends. The employee is not entitled to dividends during this time since she hasn’t received the stock yet. Also, the employer retains control over the tax treatment of the expense instead of having it depend upon whether the employee makes a Section 83(b) election.

Now, a lot of this article is complex tax code lingo. The bottom line is this: If you are looking for a way to provide an incentive to good employees, and want to avoid some of the pitfalls of stock options, then restricted stock might be a good solution for you.