Thought Leadership on Tax Planning presented by Thomas & Libowitz.
Many corporate business owners wrestle with the dilemma of how to provide equity compensation to employees on a tax efficient basis which is attractive to both the employer corporation and the employee, but are confused by the choices and tax rules. The decision tree below can be used to streamline the decision process and make the choices easier:
Options. The first question to ask is whether the employer wants the employee to pay for the stock. If the answer is yes, then the appropriate choice would be to grant the employee an option to acquire employer stock. Options allow employees to benefit from the increase in value of the stock because employees can wait until the underlying stock appreciates to exercise the option. An option can be tailored by the employer to be exercisable immediately, or in installments based upon future events, such as the employee’s continued employment for future years or the employee’s attainment of performance criteria in order for the option to be exercisable.
If the decision is made to grant options, the next question becomes whether the employer wants a federal income tax deduction for the “spread” between the option exercise price and the fair market value of the shares subject to the option at the time the option is exercised. Of course, if the employer expects a deduction, the corollary is that the employee will recognize income in the amount of the employer’s deduction.
Non-Qualified Options. If the employer expects a federal income tax deduction, the type of option granted will be a non-qualified stock option (NQSO). With an NQSO, the employee recognizes income at the time the option is exercised in the amount of the spread, and the employer is entitled to a corresponding deduction. NQSOs should be granted at an exercise price equal to the fair market value of the stock on the date of grant in order to avoid potential deferred compensation issues associated with below fair market value grants. Of course, the fair market value of the stock on the date of grant can be determined using minority interest and lack of marketability discounts, if appropriate.
Incentive Stock Options. If the employer desires to forego the deduction associated with a non-qualified stock option at the time of exercise, the employer can grant an incentive stock option (ISO). When the employee exercises an ISO, the employee does not recognize income in the amount of the difference between the exercise price and the fair market value of the stock on the date of exercise. ISOs are subject to certain rules and restrictions under the Internal Revenue Code. For instance, options must be granted pursuant to a written plan approved by the stockholders of the granting corporation within 12 months after the plan is adopted by the corporation, the options must be granted within ten years of the date the plan is adopted and cannot be exercisable after the expiration of ten years from the date of grant, the option exercise price must not be less than the fair market value of the stock at the time the option is granted, and the option may not generally be granted to any individual who owns more than 10% of the stock of the employer corporation.
Stock Awards. Suppose the employer is willing to provide equity to the employee without requiring any payment from the employee? Essentially, the equity is a substitute for a cash bonus. In this case, stock can be awarded to the employee. The award can either vest immediately, or can vest over time and be subject to the same types of restrictions on exercisability of options described above.
If the stock vests immediately, the employee will be taxed on the fair market value of the stock at the time it vests, and the employer will obtain a federal income tax deduction in the same amount. Fair market value can be determined by taking into account minority interest and lack of marketability discounts. If the stock vests over time, based, for instance, on continued employment as of specific future dates or on the achievement of performance criteria by the employee, the employee will be taxed on the fair market value of the stock at the time it vests and the employer will be entitled to deductions in equivalent amounts at such times.
Section 83(b) Elections. The vesting over time issue creates one more decision, which is whether a Section 83(b) election should be made by the employee. Since the stock vests over time based upon certain events and restrictions, the stock is subject to forfeiture if these events do not occur. Because the employee recognizes income when these restrictions lapse, the employee will, absent a Section 83(b) election, recognize income at such times and in the amount of the fair market value of the stock at the time it vests. This income could be significantly more than the income which would have been recognized at the time of the award if the value of the stock has increased by the time of vesting. To mitigate against this potential increase in taxable income, the Internal Revenue Code permits the employee to make an election under Section 83(b) of the Code to recognize income immediately based upon the fair market value of the stock on the award date rather than on the future lapse date. If the employee believes that the value of the stock will increase over time, the employee generally will make the Section 83(b) election with respect to a stock award which vests over time.
Note that the above decision tree only applies for corporate employers. The rules for partnership employers are different, and will be addressed in a subsequent article.