Building the Right Compensation Plan with Equity Incentives

A competitive compensation plan is one of the top strategies a company can deploy when trying to attract and retain top talent. Many industries have turned to equity incentives to give employees so-called “skin in the game,” but it is essential to understand the different kinds of stock options and related tax implications for employees and employers when assessing these options against more traditional compensation.

Choosing the Right Type of Equity Incentive

The most common and well-known equity incentive is the stock option. Stock options fall into two categories: Incentive Stock Options and Nonqualified Stock Options. Both have pros and cons, especially as they relate to tax implications, that can help you determine which is best for your company.

1. Incentive Stock Options (ISOs) are designed to comply with provisions of the Internal Revenue Code (IRC) section 422 and, if structured properly, can provide an invaluable tax benefit to your employees. Your employees do not have to pay income or FICA tax on the issuance or the exercise (although they may be subject to alternative minimum tax at the time of exercise); instead, tax is only paid when the employee reports selling the stock in the future.
   
   ISOs carry strict holding requirements that, if not met, will nullify any favorable tax benefits. Stock must be held for two years from the date of grant and one year from the date of exercise. After one year it will qualify for long-term capital gain treatment. Stock that does not meet these requirements will be treated as a “disqualifying disposition” and will be treated similarly to a nonqualified stock option.
   
   
2. Nonqualified Stock Options (NSO) do not comply with ISO provisions of IRC Section 422, and thus do not qualify for the same beneficial tax treatment available for ISOs. Like ISOs, if the employee holds the stock for one year from the date of exercise, the sale will qualify for long-term capital gain treatment. Unlike ISOs, employees must pay income and FICA tax after exercising an NSO, with the income calculated as the difference between the fair market value and the strike price.
   
   This income, however, is considered “phantom” income because the employee is reporting income but is not receiving any cash. The employer is responsible for submitting employee withholding taxes on the amount, even though there is no cash payment from which to withhold the taxes. Usually, employers will ask the employee to submit payment to the company to fund the exercise price and cover the cost of the withholding taxes. Otherwise, the employer may withhold a portion of the exercised stock to cover the employee’s taxes.
   

While ISOs and NSO stock options are the most common incentives, they aren’t the only options. Companies may consider alternatives such as:

• Restricted Stock Units (RSUs) – RSUs grant shares of a company’s stock to employees, typically as a reward for performance, recognition of length of service, or as an incentive to remain with the company. Recipients of RSUs don’t have immediate tax liability but must pay taxes when the RSU vests and stock shares are paid out.
• Stock Appreciation Rights (SARs) – SARs provide equity compensation tied to a company’s stock or operational performance, providing the SAR holder a payout either in cash or additional stock if the performance objectives are met during a previously specified time. SARs are typically used as a bonus provided to employees or management when the company performs well financially and are not taxed until exercised, but the income is generally taxed as ordinary compensation income, subject to FICA tax.
• Employee Stock Purchase Plans (ESPPs) – ESPPs allow employees to purchase company stock on an established schedule at a discount through payroll deductions. Many publicly traded companies use ESPPs as an employee incentive. Income from stock purchased under an ESPP is recognized and taxable when the stock is sold, although you must hold the stock for one year from the purchase date and two years from the date granted to obtain long-term capital gain benefits.

Evaluating Other Tax Considerations

Companies considering stock options as part of a compensation plan need to be knowledgeable about the reporting and tax obligations as well as potential penalties. IRC Section 409A governs the tax treatment of deferred compensation plans and provides strict guidelines on how companies value their stock options and/or stock grants. Any stock option with an exercise price less than the fair market value at the date of the grant is subject to 409A rules, which can have significant consequences for the employees, including the requirement to recognize the entire amount of the option in income while also incurring a 20% excise tax penalty.

If you are offering stock options as an equity incentive, you should have a valuation performed to ensure your stock option grants are not in violation of Section 409A. A trusted tax advisor can help you complete your 409A valuation, as well as guide you to the proper stock option plan structure and determine how to manage the granting, issuance, and exercises.

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Ori Epstein guides technology companies of all sizes as a stock option consultant and growth advisor, helping executives to secure tax savings and incentives as well as prepare for capital raises or mergers and acquisitions.