USING EQUITY COMPENSATION TO ATTRACT AND RETAIN KEY EMPLOYEES
1. INTRODUCTION TO THE ADVANTAGES AND DISADVANTAGES TO STOCK COMPENSATION PLANS
Employers use various compensation methods to motivate and reward employees. Selecting the appropriate method requires an analysis of the costs and benefits in relation to the various tax and securities laws governing such methods. Many start-up companies find it advantageous to use equity compensation. The following are the primary benefits of using stock to compensate employees:
– Gives employees incentive to be productive by giving them stake in company’s success.
– Allows employee to defer recognition of income and gain the benefit of taxation at capital gains rates.
– Addition of restrictions in stock plans can create “golden handcuffs” on various “key” employees.
– Allows company to conserve cash needed to fuel its growth.
The type of entity through which the business is operated will also have a substantial effect on the legal issues involved. Most importantly, many of the tax advantages that are otherwise available through a deferred compensation plan may be restricted for limited liability companies (LLCs), or S corporations. Consequently, prior to the implementation of a plan, an employer should always be counseled by an attorney and/or tax specialist on the legal aspects and consequences of the plan chosen.
Stock compensation comes in various forms. Employers have the option of using stock to compensate their employees (1) during the employee’s service with the company and/or (2) during the employee’s retirement or at death, i.e., deferred compensation. This article focuses on the use of stock options to compensate employers during the employee’s service with the company.
2. STOCK OPTION PLANS USED TO COMPENSATE EMPLOYEES DURING EMPLOYMENT
One of the most common methods of stock compensation is the stock option. A stock option is a contract that allows the holder to purchase a specified amount of stock at a specified price within a specified time period. The advantage is that even if the market value of the stock rises, the holder of the option may purchase the stock at the lower price set by the option contract. However, the primary disadvantage of stock option plans (and stock compensation plans in general) is the dilution of share ownership.
“Qualified stock plans” are arrangements under which the employer grants the employee stock or a stock option in the employer corporation. If these plans meet various statutory requirements found in the Internal Revenue Code, they become “qualified” for special tax treatment. However, if the stock compensation plan does not meet these requirements, then they are termed “nonqualified” plans.
3. “QUALIFIED” INCENTIVE STOCK OPTIONS (“ISO”). I.R.C & #167; 422.
An Incentive Stock Option is simply a stock option granted by employers to employees that meets various statutory requirements, thereby entitling participant employees to extremely beneficial tax treatment.
The combination of tax deferral and the favorable long-term capital gains rate makes the use of ISOs a valuable vehicle for equity compensation. Specifically an employee participating in an ISO will gain the following advantages:
– Employee incurs no income on receipt of option.
– Employee incurs no income when he or she exercises the option.
– Employee is only taxed when he or she finally sells or otherwise transfers the stock shares that were purchased pursuant to the option. More importantly, the gain recognized upon this transfer will be classified as long-term capital gain and therefore taxed at only 20%, as opposed to the individual income tax rate which can be as high as 39.6%! Furthermore, gains on shares acquired with options granted after the year 2000 will be taxed at a top rate of 18 percent if shares are held for at least five (5) years.
However, an ISO also has three major disadvantages:
– Even though employee will recognize no taxable income until stock is disposed of, he or she may be subject to Alternative Minimum Tax.1
– Employer is not allowed business expense deduction unless employee fails to satisfy holding period requirements.2
– The ISO must satisfy rigid statutory requirements, otherwise various tax benefits will not apply.
1 This is because the excess of the value of the shares on the date of exercising the option over their option price is included in calculating a taxpayer’s alternative minimum taxable income.
2 However, if the employee does not satisfy the holding period requirements, then the employee must report the gain as ordinary income and the employer receives a business expense equal to the amount of income reported by the employee. In fact, many employers often enjoy this tax deduction because many employees fail to satisfy the ISO holding periods necessary to “qualify” the plan.
