Equity-based compensation is a powerful tool for attracting, retaining and motivating executives and other employees. By rewarding recipients for their contributions to a business’s success, it aligns their interests with those of the company and provides them with an incentive to stay. This article explores several equity-based compensation options.
Equity-based compensation is a powerful tool for attracting, retaining and motivating executives and other employees. By rewarding recipients for their contributions to your success, it aligns their interests with those of the company and provides them with an incentive to stay. Here’s a look at some of the more common types.
Incentive stock options
Stock options confer the right to buy a certain number of shares at a fixed price for a specified time period. Typically, they’re subject to a vesting schedule. This requires recipients to stay with the company for a certain amount of time or meet certain performance goals to enjoy their benefits.
Incentive stock options (ISOs) offer attractive tax advantages for employees. Unlike nonqualified stock options (NQSOs), ISOs don’t generate taxable compensation when they’re exercised; the employee isn’t taxed until the shares are sold. And if the sale is a “qualifying disposition,” 100% of the stock’s appreciation is treated as capital gain and is free from payroll taxes.
To qualify, options must meet several requirements, including the following:
- They must be granted under a written plan that’s approved by the shareholders within one year before or after adoption.
- The exercise price must be at least the stock’s fair market value (FMV) on the grant date (110% of FMV for more-than-10% shareholders).
- The term can’t exceed 10 years (five years for more-than-10% shareholders).
- They can’t be granted to nonemployees.
- Employees can’t sell the shares sooner than one year after the options are exercised or two years after the options are granted.
- The total FMV of stock options that first become exercisable by an employee in a calendar year can’t exceed $100,000.
Although the benefits are substantial, ISOs also have drawbacks. Unlike NQSOs, qualifying ISOs don’t generate tax deductions for the employer. In addition, there’s a potentially significant tax risk for recipients: Employees subject to alternative minimum tax (AMT)-or whose exercise of ISOs triggers AMT-must pay tax on the spread between the exercise price and the stock’s FMV on the exercise date, regardless of when they sell the stock. In other words, they’re taxed on profits they haven’t yet realized and may lose if the price declines later. (It may be possible to recover some or all of the tax in future years through AMT credits.)
Nonqualified stock options
SQSOs are simply stock options that don’t qualify as ISOs. Typically, the exercise price is at least the stock’s FMV on the grant date (to avoid tax complications that won’t be discussed here). Also, in most cases, the NQSO itself isn’t considered taxable compensation. Rather, there’s no taxable event until the employee exercises the option. At that time, the spread between the stock’s FMV and the exercise price is treated as compensation. It’s taxable to the employee deductible to the employer and subject to payroll taxes.
Even though NQSOs are taxed as ordinary income upon exercise, they have several advantages over ISOs. For one thing, they’re not subject to the ISO requirements listed above, so they’re more flexible. For example, they can be granted to independent contractors, outside directors or other nonemployees. Plus, they generate tax deductions for the employer and don’t expose recipients to alternative minimum tax (AMT) risks.
Another choice is to grant employees restricted stock-nontransferable stock that’s subject to forfeiture until it vests (based on performance, years of service, or both). Restricted stock generally will retain at least some value even in volatile times, unlike options, which may become worthless if the stock’s price declines below the exercise price.
Generally, the FMV of restricted stock is taxable to the employee (as ordinary income) and deductible by the employer when it vests. However, the employee can reduce the tax by filing an “83(b)” election to pay tax when the stock is received, converting all future appreciation into capital gains that aren’t taxed until the stock is sold. But this strategy can be risky: An employee who makes the election and later forfeits the stock will have paid tax on income that was never received.
Review your options
If you’re considering an equity-based compensation plan, it’s important to review the pros, cons and tax implications of various approaches. If you’re not ready to share equity with employees, there are tools available that tie compensation to stock values without transferring any shares.
Daniel J. Hanson, CPA
Dan Hanson comes to Hancock & Dana with 31+ years of public accounting experience. Dan has experience in virtually all areas of taxation with broad experience in practice and project management. He joined the Hancock & Dana team in January of 2018. Dan has Bachelor’s degrees in Accounting, Banking, and Finance. His interests outside of work are fishing and golf.