Employee ownership plus a participating management style results in companies performing better than others. Neither the ownership nor participating alone accomplishes these significant gains. Companies need key employees to some extent to think and act like owners. Tech firms, in particular, increasingly attract quality employees through offering company equity.
A significant number of companies provide stock options or other kinds of individual equity to most or all of their employees. Over the past decade, the number of companies sharing ownership with employees grew substantially.
Employee ownership benefits owners, employees and their companies in a variety of ways. First, employee ownership helps align employees with the interests of the company, thereby promoting dedication to the company. Second, employee ownership assists the company in attracting and retaining quality employees. Third, employee ownership provides a possible path for buying out an existing owner when making that business decision becomes necessary. Finally, in some service firms or family owned businesses, employee ownership helps companies raise and conserve capital by exchanging equity for lower wages and provide valuable tax benefits for the company.
Companies typically motivate, attract, and retain good employees through a combination of financial and non-financial compensation programs. A strategic combination of the two typically produces optimal results for the company and the employees alike.
There are a few types of equity composition instruments that companies typically utilize. These include stock options in the form of either incentive stock options (“ISOs”) or non-qualified stock options (“NSOs”), restricted stock. Stock options give employees the right to buy or “exercise” a certain number of shares of the employer’s stock. Stock options typically are subject to vesting such that employees have the right to purchase a certain percentage of shares over a specified period of time. For example, 25% after two years, 50% after three, 75% after four, and 100% after five years. This mitigates flight risk and assists employee commitment.
Incentive stock options
ISOs are a class of options created by the IRS and subject the Internal Revenue Code rules, which if followed, qualify the options for preferential tax treatment. Hence, they are also known as “qualified stock options.” To qualify for such tax benefits, ISOs must meet multiple eligibility requirements, including:
- Must be granted to an employee
- Under a written ISO agreement
- At a price equal to or greater than the “fair market value” (pursuant to Section 409A of the Internal Revenue Code, discussed more below) at the time of grant
- Via a written plan specifying the total number of shares that may be issued and the eligible employees
- The plan must be approved by the stockholders within 12 months either before or after the plan’s adoption
- Employee must not, at the time of grant, own stock representing more than 10% of the voting power of all stock outstanding
- The option must be exercised within 10 years of grant
- The aggregate value of any ISO stock exercised for the first time cannot exceed $100,000 in any given year
An employee may buy stock at a specified price which complies with Section 409A (not less than 100% of fair market value) for a given period of time (10-year maximum). Options may be exercised in any sequence, but the annual value of ISOs which become exercisable in any one year cannot exceed $100,000 per individual. The appreciation in value of the options from grant to sale qualifies for capital gain treatment, provided the holding period requirements are met – stock must be held for at least two years after grant, and one year after exercise.
There are certain tax consequences associated with ISOs for both employees and employers. An employee receiving ISOs realizes no income upon their receipt (at grant) or exercise. The employee is taxed upon a qualifying disposition (one held for the holding period) at capital gains rates. Disqualifying dispositions are taxed as ordinary income. Note that alternative minimum tax can kick in depending on circumstances.
An employer is not entitled to a deduction with respect to the issuance of the option or its exercise. If the disposition of the stock is qualifying, the employer receives no deduction. However, if the employee causes the option to be disqualifying (by disposing of the stock prior to the end of the holding period), the employer generally may take a deduction for the amount recognized by the employee as ordinary income in the same year as the employee recognizes the income.
In sum, advantages to ISOs include the fact that an employee’s tax liability is deferred until stock is sold, long exercise period allows employee flexibility and can be retentive, and employee may defer taxes or may sell the stock earlier in a disqualifying disposition. Disadvantages to ISOs include the fact that employee investment is required at exercise, company loses tax deduction, spread at exercise is considered tax preference item for purposes of computing alternative minimum tax, and that they are more complicated instruments for administration.
Non-qualified stock options
All options outside of ISOs, including ISOs that fail to meet the requirements or otherwise qualify as ISOs are rendered NSOs. NSOs are defined as options that do not qualify or fail to meet ISO requirements. With NSOs, an employee may buy stock at exercise price for a given period, so long as the valuation complies with Section 409A. The appreciation from grant date to exercise date is taxed at ordinary income rates. If an employer or employee fails to adhere to the restrictions of an ISO, the stock
automatically reverts to non-qualified status.
NSOs differ from ISOs in several ways. They are far more flexible and easier to administer. They can be given to anyone – partners, consultants, board members, advisors etc. They are typically taxed at exercise at ordinary income tax rates. They provide the employer with an accompanying compensation tax deduction equal to the income recognized by the employee.
If, as is almost always the case with non-publicly traded companies, the NSOs do not have a readily ascertainable fair market value at the date of grant, there is no taxable event at the time of grant. The tax event occurs at the time the employee exercises the option. The employee will be taxed at the ordinary income rates for the amount equal to the difference between the fair market value of the stock at exercise and amount paid for the option. The employer has a corresponding deduction in the same amount at the same time as the ordinary income is recognized by the employee. If the stock is held after exercise, any additional gain to the employee is generally treated as capital gain.
In sum, advantages to NSOs include the fat that the company receives a tax deduction when employees exercise their options, with no limitations on the amount of options that may be exercised. NSOs offer potential for long-term appreciation as the company grows. Disadvantages include the fact that employee investment is required, and that employees incur tax liability at exercise of their options.
ISOs vs. NSOs: Tax Consequences
There are certain preferential tax treatments available via ISOs. For one, ISOs are taxed when the employee sells the stock, not at the time of grant or exercise, while NSOs are taxed on the date of exercise. Therefore, with ISOs, paying taxes on unsold but exercised option stock is avoided (which potentially could become worthless) and profit is not realized unless and until the stock is sold.
ISO shares may receive long-term capital gain tax treatment. If the holding period is met – i.e., the later of one year after the stock is transferred to the employee or two years after the option is granted – the ISO stock is taxed at the lower long-term capital gains rate. By contrast, NSOs are taxed at the ordinary income rate.
Note that the alternative minimum tax requirements may apply in certain situations, thereby reducing the tax benefits of ISOs.
Restricted stock refers to stock in a company with limitations attached. Common examples of limitations include requiring a certain amount of time pass and certain goals achieved prior to the stock being transferable and subjecting the stock to forfeiture if employment is terminated. Upon satisfaction of the limitation conditions, the stock vests and becomes transferable.
The grant of restricted stock is an outright grant of the underlying shares with restrictions attached as to sale, transfer, and pledging. The restrictions lapse over a period of time (e.g., three to five years), and as restrictions lapse, the employee has unrestricted shares which may be sold, transferred, or pledged subject to limitations in corporate documents such as the company’s stockholders’ agreement. If the employee terminates employment, all unvested shares are forfeited.
During the restriction period, the employee receives dividends and can vote the shares.
Restricted stock is also associated with certain tax consequences for the employee and the employer. Tax impacts on the employee, absent making a Section 83(b) election, include no tax at grant, and taxation of vested shares as ordinary income as restrictions lapse. Dividends received during the restriction period would be taxed as ordinary income.
The tax impacts on the company, absent making a Section 83(b) election, include no tax deduction at grant, and receipt of tax deductions equal to employees’ ordinary income as restrictions lapse. At sale, there are no tax deductions. Dividends paid during the restriction period are deductible by the company when paid.
In sum, advantages to restricted stock include the fact that no employee investment is required, immediate stock ownership is promoted, it is recognizable to most employees, and it offers the employees potential long-term appreciation as the company grows. Disadvantages include immediate dilution of earnings per share, and potential for employees to incur tax liability before the shares are sold.
An 83(b) election is an option to pay taxes on the total fair market value of restricted stock at the time of granting. Advantages of making the election include allowing employees to pay tax at receipt, thereby locking in the low value of the stock rather than paying a higher tax after the value of the stock appreciates. Also, the capital gains holding period begins at grant of the stock and not at vesting.
Disadvantages to making the election include accelerated payment of taxes (the election must be filed with the IRS within 30 days of receipt of the stock), overpayment of taxes in case the value of the stock decreases, potential to pay substantial income tax on stock which may not be valuable if fair market value is set high due to venture capital funding, and no loss deductions if stock is forfeited.
Phantom stock refers to a type of incentive grant in which a promise to pay a bonus based on some formula or allocation is made, and the recipient is not issued actual shares of stock on the grant date, but rather receives “hypothetical” stock (the company gives the employee the benefits of owning stock without actually granting stock). Phantom stock increases or decreases in price and pays “dividends” as if it were real. Eventually, the phantom stock is settled, and cash is distributed to the employee. Phantom stock distributions are not “qualified” and are taxed as ordinary income at distribution.
Stock Appreciation Rights (“SARs”)
SARs are contractual arrangements between a company and an individual, usually an employee, whereby the recipient has the right to receive an amount equal to the appreciation on a specified number of shares of stock over a specified period. SARs are normally paid in cash but can also be paid in shares. Generally, a recipient’s ability to exercise a SAR is subject to a contractual “vesting” provision that expires after a specified period, either all at once or in increments. SARs may be granted in conjunction with options – to pay for their purchase at exercise.
SARs differ from stock options because the recipient is not required to pay an amount to exercise the SARs, and only receives the appreciation in the value of the stock between the date of grant and date of exercise (generally, the recipient controls the timing of exercise). Also, the recipient generally does not receive any shares of stock of the granting company.
Phantom Stock and SARs: Tax consequences
Phantom stock and SARs feature tax consequences for both employees and employers. Employees are taxed when the right to the benefit is exercised. At that point, the value of the award, minus any consideration paid for it (there is usually none) is taxed as ordinary income to the employee and is deductible by the employer. If the award is settled in shares (as may occur with an SAR), the amount of the gain is taxable at exercise, even if the shares are not sold. Any subsequent gain on the shares is taxable as capital gains.
Special considerations for S Corporations and LLCs
S corporations are treated as corporate entities and ISOs are available. Upon filing an 83(b) election or exercising options, the holder is considered a stockholder. This is relevant to S corporations because S corporations are limited to one hundred shareholders. Phantom stock and SARs are possible in S corporations so long as the company does not create a second class of stock.
There are high administrative costs and complexity in pass through LLCs. ISOs are not available to LLCs except where the LLC has elected to be taxed as a C corporation. The value of unrestricted capital interests granted (less anything paid) is ordinary income, and deduction is available to the LLC. Restricted capital interest is taxed at the time of vesting and deduction is available. 83(b) elections are available to LLCs.
Section 409A: Fair Market Value
Congress enacted Section 409A of the Internal Revenue Code as part of the American Jobs Creation Act of 2004 in response to perceived abusive compensation practices. Section 409A applies to non-qualified deferred compensation (“NQDC”) plans. Deferred compensation plans which do not meet the specific
requirements of 409A are treated as “current income” and subject to a significant excise taxes plus penalties. Section 409A of the Internal Revenue Code applies to employees, directors and “other service providers.” Section 409A contains very specific rules governing the timing of deferrals, timing of distribution, funding methods and various other aspects of deferred compensation.
There are significant penalties for non-compliance with Section 409A. If there is a violation, affected service providers owe current tax on deferrals for the current year and all prior years (to the extent not subject to a substantial risk of forfeiture). Interest is charged at the underpayment rate plus 1% from the original deferral date. Also, an additional tax of 20% of the taxable compensation attaches.
While Section 409A defines deferred compensation broadly to include elective deferred compensation plans as well as non-elective arrangements, exceptions exist to 409A coverage, including non-discounted stock options, restricted stock, and SARs. In order to fall within the 409A exception however, the equity compensation instrument must be value at fair market value at the time of grant.
Value under Section 409A is determined “by the reasonable application of a reasonable valuation method.” It is deemed unreasonable to use previously calculated value that fails to reflect all material information, or calculation that is more than twelve months old.
In the event of audit by the IRS, there are two primary safe harbors to Section 409A: a written valuation report for illiquid stock by a person with significant knowledge and experience, and independent appraisal (which can cost a cash strapped start-up up to $5,000 to $7,000). If a safe harbor is met, the IRS must accept the valuation is reasonable unless they can demonstrate that the valuation is “grossly unreasonable.”
A reasonable valuation is one that has a “reasonable method, reasonably and consistently applied.” It would take into consideration the value of tangible and intangible assets, the present value of future cash-flows, the market value of stock or equity interests in similar companies and other entities engaged in businesses substantially similar to those engaged by the corporation, recent arm’s length transactions involving the sale or transfer of the stock, and other relevant factors, such as control premiums or lack of marketability.
According to IRS guidelines, 409A valuations should include the following:
- The value of tangible and intangible assets;
- The present value of future cash-flows;
- The market value of stock or equity interests in similar companies and other entities engaged in businesses;
- Recent arm’s length transaction involving the safe transfer of the stock; and
- Other relevant factors, such as control premiums or lack of marketability.