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I have prepared a discussion of equity participation compensation plans commonly used by companies to reward their executives. Equity arrangements are commonly used instead of cash bonus plans because of their favorable tax and accounting treatment.
A stock option gives the recipient the right to purchase stock of the company at a fixed price (the "exercise price") for a defined period of time (the "option term"). Stock options are the most common form of equity incentive offered by corporations. One of the reasons for the popularity of stock options is that they are simple to design, administer, and communicate. Stock options bond the recipient and the shareholder through a common interest in increasing the company's stock price by offering the recipient an uncapped upside potential equal to any increase in the price of the stock. Stock options are advantageous from a corporation's perspective because they require no charge to company earnings, they generally result in a positive cash flow to the company at the time of exercise, and they promote retention of key employees through vesting restrictions and the long-term nature of the investment.
Despite the above mentioned advantages, stock options also have several disadvantages. Stock options do not focus recipients on the long-term financial goals of the issuing company. Because they are linked to the stock performance of the overall company, options do not reward specific executives for their performance. Options ignore the fact that for many companies changes in stock price are dependent on stock market movement and other external factors than company performance. These external factors are outside of management's control. Option gains are often more a function of timing and luck than a true reflection of the company's performance. Like most equity plans, options are subject to SEC and stock exchange regulations that limit flexibility and often require shareholder approval.
From a tax perspective, there are two types of stock options, incentive sock options ("ISOs") and nonqualified stock options ("NQSOs").
An ISO Plan must be approved by the shareholders of the company and must specify the aggregate shares available and the employees eligible to receive the shares. Under the Internal Revenue Code of 1986, as amended (the "Code") § 422, options must satisfy the following criteria to qualify as an ISO:
1. Options may not be granted with an exercise price less than the fair market value ("FMV") of the underlying stock on the date of grant;
2. Option grants made to individuals owning more than 10% of the outstanding shares must have a minimum exercise price of 110 % of the fair market value, and a maximum exercise period of five years;
3. Options may not have an exercise period in excess of ten years and the option must be granted ten years from the earlier of the date the plan is adopted or the date the plan is approved by the shareholders;
4. The grant value (number of shares times value of the shares at the time the option is granted) is capped indirectly through vesting restrictions. The value of shares of employer stock that can be exercised for the first time by an employee in any one year under an ISO can not exceed $100,000, based upon the value of the stock at the date of the ISO's grant. For example, if a corporation grants 100,000 options to purchase its stock to an employee in 1996, which are immediately exercisable, the options will qualify as ISOs if the stock's value is $1.00 per share;
5. Exercised options must be held for the longer of (a) one year following exercise, or (b) two years following grant;
6. Following the employee's termination (except in the case of death or disability), vested options must be exercised within 90 days or forfeited;
7. Options are not transferable, except upon death; and
8. Options may only be granted to employees.
Options that qualify as ISOs receive preferential treatment. No taxable income is realized by the employee at the time of grant or timely exercise of an ISO. Because the option grant is not treated as compensation, the employer does not receive a deduction or pay FICA tax. When the stock is eventually sold, any gain from the date of grant through the date of sale is treated as a capital gain if the stock was held for the periods described above. No FICA tax or income tax is withheld upon the sale. If the stock was not held for the required period (a "disqualifying disposition"), any difference between the gain will be taxed at ordinary income rates. Upon a disqualifying disposition, the employer may deduct the spread. For alternative minimum tax ("AMT") purposes, the spread upon exercise is a tax preference item. However, any gain upon sale of the stock will be offset by an AMT credit. Further, if the exercise period of an option is accelerated due to a change in control of the company, the exercise may result in a "parachute payment" for golden parachute excise tax purposes.
Employees desire ISO treatment because they can defer taxation to the date they sell their stock, the option spread is taxed as a capital gain, and the spread is not subject to FICA. As discussed above, the employee is also given the opportunity to participate in the future growth of the company. In addition to the advantages discussed above, the company would benefit from ISOs in that it does not have to pay FICA tax and the options are not subject to ERISA participation, vesting, or anti-discrimination rules.
A disadvantage to the employee of ISOs is that the employee must finance the option exercise price. However, the plan may provide that the company may loan the exercise price to the employee or the employee may be able to finance the purchase with shares of stock. Options are less liquid than cash incentives and inherently contain more risk. Further, because of the vesting rules, options provide less mobility for the employee. The major disadvantage for the employer is the denial of a deduction for the options. Additionally, ISOs may be inadvertently disqualified by company actions, such as modifying or enhancing previously granted options. Options dilute outstanding stock. As discussed above, because stock prices are not tied to performance of executives, options are a less direct incentive than cash arrangements.
Unlike ISOs, NQSOs are not strictly regulated and are thus more flexible in determining the option price and term. There is no limit on the number of options that can be granted or vested in a particular year. There are no restrictions on the disposition of the acquired stock. Nonqualified options are generally divided into FMV options, discounted options, and premium priced options.
Most NQSOs have an exercise price equal to the FMV of the issuing company's stock on the date of grant. FMV options are simple to design. Additionally, they preserve the favorable accounting treatment generally associated with options.
A discounted stock option is a nonqualified option with an exercise price below the FMV of the issuing company's stock on the date of grant. The amount of the discount varies from 10% to 80%. However options discounted more than 50% may be categorized as restricted stock for tax purposes. The issue is whether the option is so likely to be exercised that, in economic reality, it is really a transfer of the stock and therefore taxable under Code § 83. Unlike FMV options, discounted options provide value at the time of grant equal to the discount. The discount makes the option less risky and more valuable to the recipient. The main disadvantages of discounted options are that they require a charge to the issuing company's earnings equal to the amount of the discount and they are generally disliked by shareholders who believe the discount is a gift.
Premium-priced options have an exercise price greater than the FMV of the issuing company's stock on the date of grant. Premiums are typically 10% to 25%. Shareholders like premium-priced options because of their elevated exercise price. Recipients perceive the options to be very risky and less valuable.
The grant of a NQSO is not a taxable event. Upon exercise, the tax treatment depends upon the restrictions placed upon the stock received. If the stock received upon exercise is transferable or not subject to a substantial risk of forfeiture, the employee recognizes ordinary income equal to the spread between the exercise price and the FMV of the stock when the option is exercised. The company is entitled to a deduction for the amount that is taxed to the employee. If the stock is not transferable or is subject to a substantial risk of forfeiture, taxation is deferred until the restriction lapses. The employee can waive the deferral by making an election under Code § 83(b). The company is required to withhold taxes on the exercise of a NQSO. Because the company can take a deduction, Companies prefer NQSOs to ISOs.
A restricted stock grant is an outright grant of stock at nominal or no cost that is subject to vesting and forfeiture restrictions. Such restrictions are typically tenure based. Although the stock is restricted, the employee generally has the right to vote the stock and receive dividends. During the restricted period, typically one to five years, the shares revert back to the company if the restrictions are not satisfied.
Restricted stock's main advantage is that it retains employees because of the value of the stock granted. Also, restricted stock creates less drain on cash flow than cash arrangements. Restricted stock, like options, has significant accounting advantages over cash arrangements. The company's accounting charge is based on the price of the stock at the time of grant, less any payment. If the stock increases, there is no additional charge to earnings. The accounting charge may be spread over the restriction period. The company's tax deduction is equal to the price of the stock at the time the restrictions lapse. If the price increases, the tax deduction will be greater than the accounting charge. Because the recipient's tax liability is deferred until vesting occurs, restricted stock provides tax benefits to the recipient. Unlike options, the recipient generally does not have to pay cash or use stock to purchase the stock.
The major disadvantage of restricted stock is that shareholders dislike it because there is no risk and it is not performance based. Further, restricted stock is more dilutive than options because the company receives no payment for the stock. Disadvantages to the employee include the stock is subject to a risk of forfeiture if the recipient does not satisfy the restrictions and tax may be payable on the stock when the employee does not have sufficient tax to pay the liability.
Restricted stock, like NQSOs, is taxed under Code § 83. The employee is not taxed at the time of transfer, nor does the company receive a deduction. The recipient receives ordinary income at the earlier of time that the stock either becomes transferable or ceases being subject to a substantial risk of forfeiture. The company takes a deduction when the employee recognizes income. The employee may elect under Code § 83 to include the FMV at the time of transfer in income. Withholding is required. To the extent the stock is not vested, dividends received are taxed as ordinary compensation and the company may take a deduction.
Stock appreciation rights ("SARs") grant the recipient with a cash payment equal to any appreciation in the price of the issuing firm's stock over a specified period of time. SARs are generally granted in tandem with options. Exercise of a SAR typically cancels an equal number of the options. SARs may be payable in cash or in stock. Some companies have adopted "limited" SARs which spring into effect only upon certain events generally associated with a change in control.
The main advantage to the employee of an SAR is that it does not require an upfront investment and thus solves financing and liquidity problems associated with options. In consequence, SARs are less risky than options. A significant disadvantage of the SAR is its accounting treatment. The company must accrue the entire value of the potential payment as a charge against the firm's income statement. If the stock value increases, this can be a substantial burden. Other disadvantages of SARs compared to options is that they do not promote actual stock ownership and they result in a cash outlay by the issuing firm.
The grant of an SAR has no tax consequences. Upon exercise, the spread is taxable to the employee as ordinary income. The company receives a deduction and is required to withhold tax.
Phantom stock plans take various forms. Basically, the employee and company enter into an agreement that at some future point (perhaps five years) or some event (such as retirement) the company will make a cash payment to the employee equal to the value of the phantom stock unit. Some phantom stock units are similar to SARs- the value of a unit of phantom stock equals the appreciation in the FMV of a share of the company's stock between the grant date and the settlement date. Other plans may base a phantom stock unit upon the value of a share of stock on a particular date (the recipient does not actually receive the stock only the cash equivalent). In other cases, the value of a phantom stock unit may be tied to some other factor such as earnings, growth in book value, or some other performance factor (these plans are called "performance units"). During the contract period the employee has no rights as a shareholder. The promise is an unsecured promise (typically unfunded) of the company. Thus, the plan is a form of a nonqualified deferred compensation plan.
Like SARs, one of the advantages of phantom stock plans is that the recipient does not have to make an upfront investment but may still benefit from the growth of the company. Further, the plan provides a means of enhancing retirement income. The company may defer cash compensation payments through a phantom stock plan.
A disadvantage of these plans to the employee is that it relies upon the solvency of the company to pay the unfunded promise. Further, the employee does not actually own the stock and can not vote the stock. From the companies perspective, the disadvantages are that the plan requires an accounting charge to earnings, the tax deduction is delayed, and the increase in stock may not be related to company performance. Further, shareholder approval may be required. If shareholder approval is not obtained, the plan may be challenged as a waste of corporate assets unless a ceiling is imposed to prevent runaway compensation.
Employees are taxed on phantom stock awards when the awards are settled in cash, stock, or a combination of both. The payment is taxed as ordinary income. Acceleration of vesting due to change in control would be considered a "parachute payment" for golden parachute tax purposes. The company is entitled to a deduction when payments are made as long as the compensation is "reasonable".
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Questions, comments or suggestions? kbercik@taxcounsellor.com
Last updated March 30, 1998