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Using Equity as Compensation Tool

Equity is one of the most powerful tools available for attracting, retaining, and motivating employees. Offering employees a stake in your company’s success aligns their interests with those of the owners, rewards them for excellent performance, and provides them with an incentive to stay with the company for several years. Here’s a quick review of some of the ways you can share equity with employees. Although this discussion focuses on corporations, there are a variety of incentive compensation tools for LLCs and partnerships as well.

Stock Options

Stock options give employees the right to buy shares at a fixed price for a specified number of years (10 years is common but shorter periods may be used). Typically, options vest gradually over several years. For example, one-third of the shares might vest each year for three years.

The tax treatment of options depends on whether they’re nonqualified options (NQOs) or incentive stock options (ISOs). NQOs are taxed upon exercise as ordinary income. Say an employee receives options to buy 100 shares for $50 per share. The employee exercises the options five years later, when the options are fully vested and the shares are worth $80. The employee’s $3,000 gain is treated as ordinary income, which is taxable to the employee and deductible by the employer.

ISOs are not subject to tax when exercised. Rather, they’re taxed when the shares are sold and the spread between the exercise price and the sale price is treated as capital gain. Although this tax treatment is attractive to employees, ISOs have several disadvantages:

  • Unlike an NQO, the spread is not deductible by the employer.
  • The employee must hold the shares until the later of 1) one year after the options are exercised or 2) two years after the options are granted.
  • They must be granted at fair market value (110% of FMV for 10% shareholders).
  • The term cannot exceed 10 years.
  • No more than $100,000 in value (measured at the grant date) can become exercisable by any individual employee in any one year.
  • They can’t be granted to non-employees.
  • Employees subject to alternative minimum tax may have to pay tax on the spread upon exercise even if they haven’t sold the shares (and even if the price declines in later years).

Although NQOs trigger ordinary income taxes, they’re simpler and more flexible than ISOs and present no AMT risk.

Restricted Stock

Restricted stock involves a grant (or, in some cases, a discounted sale) to an employee of stock that’s nontransferable and subject to forfeiture until it’s vested (typically based on performance, years of service, or both). Restricted stock generally has less upside potential than options, but unlike options, it retains value even during times of market volatility. Once restricted stock vests, however, its market value (less the purchase price, if any) is taxable as ordinary income (and deductible by the employer).

The employee can avoid this result by making an “83(b) election” to pay the tax when the stock is received and convert all future appreciation into capital gains. Generally, the election results in a lower overall tax bill, but it’s also a bit of a gamble: If the employee forfeits the stock (for example, by leaving the company before the stock vests), he or she will have paid tax on income that’s never received.

Phantom Stock and Stock Appreciation Rights

One drawback of equity-based compensation, particularly for smaller companies, is that it dilutes the owners’ interests. Phantom stock and stock appreciation rights (SARs) offer employees many of the benefits of stock ownership without transferring any shares. These tools provide employees with cash compensation (taxed as ordinary income) that are tied to the value of a set number of shares — or, in the case of SARs, the increase in that value. Like the tools discussed above, phantom stock and SARs can be designed to vest based on years of service or performance.

Consult Your Advisors

Sharing equity with employees raises a variety of business and tax issues, including complex deferred compensation rules. Be sure to consult your advisors to ensure that your compensation plan is appropriate for your business and complies with applicable tax regulations.