Start-up companies seeking to incentivize founders and retain key employees often present such individuals with equity in their companies as part of the individuals’ overall compensation packages. Equity-based compensation is intended to align the interests of the employees with the interests of the company’s shareholders and investors. Simply speaking, the better the company does overall in the long term, the better the employee does overall in terms of compensation received in the long term.
The implementation of equity-based compensation by companies can be complex and uniquely challenging, taking into consideration countless laws and requirements ranging from securities law considerations, tax law considerations, corporate law considerations as well as practical business considerations.
This discussion will focus on some of the common types of equity compensation offered to incentivize and retain employees from corporations (C corps) and the overall tax considerations and practical implications of receiving such forms of equity-based compensation.
Stock Options
A stock option is a right to buy stock in the future at a fixed price. It is typically subject to the satisfaction of different vesting conditions, such as continued employment with a company or achieving specific performance-based metrics before the recipient can exercise the options.
The two types of stock options presented to employees are either in the form of incentive stock options (“ISOs”) or non-qualified stock options (“NQOs”). The differences between the two types of stock options are all tax-related. ISOs are generally viewed as more tax advantageous to the recipient than NSOs and therefore come with more requirements.
Incentive Stock Options (“ISOs”)
ISOs offer favorable tax treatment for employees if specific requirements are met. Upon the exercise of an ISO, employees typically will not recognize any compensation income and will only recognize income upon the sale of the stock. If all of the ISO requirements are met, including the statutory holding periods, then the employee will be eligible to receive long-term capital gains treatment upon the sale of the stock and absent of any withholding requirements relating to payroll taxes. Companies will be entitled to a compensation deduction upon the sale of the underlying stock equal to the amount of compensation income (if any) recognized by the employee if the holding period described below is not met. However, if the ISO holding period is met, no compensation deduction will be made available to the company. In the event that the holding period for the ISO is not met, then a “disqualifying disposition” will be deemed to have occurred, resulting in the employee recognizing ordinary income at the time of the sale equal to the spread (i.e., the difference between the fair market value of the stock at the time of exercise and the exercise price of the option).
To qualify as an ISO, among other things, the ISO must meet several requirements:
- Must be granted pursuant to a written plan that is subject to shareholder approval;
- Can only be granted to employees of the company;
- The exercise price must be at least the fair market value of the stock on the date of the grant (110% of the fair market value in the case of a grant to a 10% or more shareholder);
- The term of the option may not exceed ten years (five years in the case of a grant to a 10% or more shareholder);
- The total value of the stock options that can be exercisable by an employee in any given calendar year cannot exceed $100,000 (any excess will be treated as an NSO);
- ISO must be held for more than two years after grant and the shares obtained upon exercise of an ISO must be held for more than one year after exercise; and
- ISO must be exercised within three months following termination of employment, except in the case of death or disability.
Any failure to not satisfy all of the ISO requirements will result in the ISO being treated as an NQO.
Non-Qualified Stock Options (“NQOs”)
NQOs are all other stock options that do not qualify as ISOs. Unlike ISOs, NQOs do not qualify for any special tax treatment to the recipient and may be granted to a larger pool of individuals, including employees, directors, and consultants. Individuals will generally be required to recognize compensation income upon the exercise of a NQO in the amount equal to the spread between the stock’s fair market value on the exercise date and the NQO’s exercise price. Companies will be entitled to receive compensation deduction equal to the same amount of compensation income recognized by the employee. They will also be required to withhold the applicable federal, state, and local income taxes and FICA taxes on the income recognized. When the stock is eventually sold, the employee will recognize capital gain or loss treatment, either long or short-term depending upon the stock’s holding period, based upon any changes in the stock price since the exercise date.
Restricted Stock
Restricted stock is stock that is either sold or granted to a recipient and is subject to vesting and forfeiture if certain vesting conditions are not satisfied. Companies may grant restricted stock to employees, directors, or consultants outright or require the individuals to purchase the stock at or below its fair market value. The recipient of restricted stock is subject to vesting conditions such as the requirement for continued employment with the company and/or the achievement of specific performance-based metrics. During the vesting period, the restricted stock is considered outstanding to the recipient, and as such, the recipient is eligible to receive dividends as to the unvested stock. Any dividends paid by a company with respect to any unvested stock shall be taxed as compensation income to the recipient and will be subject to withholding by the company. In contrast, any dividends paid on vested stock shall be taxed as dividends and will not be subject to any tax withholding requirements by the company.
As restricted stock vests, the recipient will recognize compensation income and will be taxed upon the fair market value of the stock (less any amounts paid for the stock) at ordinary income tax rates unless an 83(b) election has been made with the IRS within 30 days of the grant date. An 83(b) election enables the recipient to recognize taxable income on the entire value of the restricted stock (less any amounts paid for the stock) at the time of the grant date without having to wait for the stock to vest. This election is irrevocable and can be a valuable tool in minimizing ordinary income tax while maximizing capital gains to restricted stock recipients wishing to being the holding periods on the stock at an earlier date. If an 83(b) election is not made, however, then the company must withhold any applicable federal, state, and local income taxes and FICA taxes on the income recognized.
Restricted Stock Units (“RSUs”)
Restricted stock units are contractual rights to receive stock in a company or an equivalent cash payment at a future point in time. Unlike a stock option, which gives the option holder the right to purchase shares of a company’s stock at a predetermined price, usually at a discounted price, with RSUs the recipient is awarded the full value of the stock on the date of delivery. RSUs are considered deferred compensation rather than property and therefore there are no tax implications when a company grants RSUs but are taxed as compensation income to the recipient as the RSUs vest. As RSUs vest, companies are entitled to receive compensation deduction equal in the same amount of compensation income recognized by the employee and will also be required to withhold, on the same amount, the applicable federal, state, and local income taxes, as well as FICA taxes. If the shares are sold immediately upon vesting, then there is no capital gains treatment only ordinary income treatment based upon the value of the shares received. If the shares are held beyond the vesting date, then capital gain or loss treatment may be realized depending upon the holding period of the shares.
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