This post is the third in a series exploring ways to attract and retain key employees, directors, and other service providers of privately held companies (herein “service providers”) through equity-based compensation arrangements and alternative arrangements that provide cash payments tied to the value of the company’s stock.

Previously, in the first and second posts of this series, I provided a general overview of four alternatives available to private companies to provide equity-based compensation to key employees and other service providers and some of the factors used to select among these alternatives. In this post, I’ll describe the federal income tax treatment of stock options, restricted stock, phantom stock, and stock appreciation rights, both from the employer and employee perspective.

Stock Options

There are two types of stock options for tax purposes, nonqualified options (“NQSOs”) and incentive stock options (“ISOs”) (also sometimes referred to as statutory stock options).

From the service provider side, NQSOs result in:

  1. no tax consequences at the date of grant of the option and
  2. compensation income (i.e. income tax at “ordinary income” rates and FICA taxes) to the service provider on the “spread” at the date of exercise of the option.

The “spread” is the value of the share of stock at the date of exercise over the exercise price. This tax treatment (i.e. taxed at date of exercise and not date of grant) is applicable in most cases except in the rare event that the options in the privately held company have a readily ascertainable fair market value at the date of grant. On a subsequent sale of the stock, the service provider may get long-term capital gain treatment, taxed at 15% (at least until January 1, 2013)

From the employer side, NQSOs result in:

(i) no tax consequence at the date of grant and

(ii) a tax deduction on the amount treated as compensation income to the service provider at the date of exercise (again, except in the rare case of stock that has a readily ascertainable market value at date of grant). On a subsequent sale of the stock by the service provider, there is no tax consequence to the employer.

On the other hand, incentive stock options are given special tax treatment under Internal Revenue Code Sections 421 and 422. Specifically, there is no tax at date of grant or at date of exercise and the employee (only employees may receive ISOs) may receive long-term capital gain treatment on a subsequent sale of the stock if the stock received upon exercise of the ISO is held at least a year after exercise and at least two years from the original date of grant of the option.¹ In addition, FICA taxes do not apply to ISOs. From the employer side, however, the tax treatment is less favorable; there is no tax deduction at date of grant, exercise or on a subsequent sale.

To achieve ISO status, there are several requirements which must be met. Briefly, these requirements include, but are not limited to:

  1. Only employees may receive ISOs
  2. The plan must be approved by the stockholders
  3. The plan must set forth a maximum number of shares and the employees or class of employees eligible to receive options
  4. Options cannot have a term exceeding ten years (five years for 10%+ shareholders)
    The exercise price is not less than fair market value at date of grant (110% of fair market value for 10%+ shareholders

In addition to the general tax treatment for options, Code Section 409A is critically important. Without delving too deep into the details, issuers of stock options need to know that they must issue the stock option with an exercise equal to or exceeding fair market value on the date of grant. If stock options are issued with an exercise price below fair market value, then the option would be subject to Code section 409A, and in almost all cases would not comply. The result would be significant taxes and penalties assessed against the service provider.

The most problematic part of Code section 409A for privately held companies is determining the fair market value of a share of stock at date of grant. Many privately held companies, particularly those in a growth phase, are short on cash flow and don’t want to pay for an appraisal. Fortunately, Treasury regulations provide that a company may use a number of methods to determine fair market value, including “a reasonable application of a reasonable method”. The most important point is that the board of directors needs to take into account all relevant information, including third-party offers for purchases of stock, and apply a reasoned approach to determine value. And perhaps most importantly, the methodology and the price need to be well documented in the issuer’s board minutes.

Restricted Stock

Restricted stock is taxed under Code Section 83 governing transfers of property. If the stock granted is non-transferable and subject to a substantial risk of forfeiture, which will exist when

(i) the service provider must continue performing substantial services for some period of time for the stock to vest and/or

(ii) there are certain performance based conditions, then the restricted stock is not taxed at grant.²

Instead, the stock will be taxed when it is vested as compensation income (at ordinary income rates and FICA). In addition, any income to the service provider before the stock is vested, such as dividends, will be treated as compensation income to the service provider. On the employer side, it will receive a tax deduction equal to the amount included in the income of the service provider at the time the stock is included in the service provider’s income.

However, there is an election available under Code section 83(b) which allows the service provider to elect to take the stock into account for tax purposes at date of grant. Although deferral of income is normally the goal, with restricted stock it may (and often does) make sense to make the 83(b) election if the stock is expected to increase in value after date of grant. The result of the 83(b) election for stock increasing in value is that the recipient pays tax on a low value at date of grant and achieves capital gain treatment for a subsequent sale of the stock at a higher value. The 83(b) election must be made within 30 days of the date of grant.

Restricted stock is generally not subject to Code section 409A.

Phantom Stock and Stock Appreciation Rights

Phantom stock (also sometime structured as restricted stock units) and stock appreciation rights (SARs) generally result in compensation income to the service provider upon the date of payment and the employer gets a deduction for the amount taxed to the service provider.

However, for FICA tax purposes, there is a special timing rule for phantom stock plans which provides that the income is taxed at the later to occur of the time when the services are performed or when there is no substantial risk of forfeiture. FICA taxes on SARs are generally applied on vesting.

Both phantom stock plans and SAR plans are usually structured to avoid the necessity of complying with Code section 409A. This is done by having the award paid out under the short-term deferral exception (payment to the service provider within 2½ months after the end of the taxable year in which the award vests). However, if the short-term deferral exception is not used, then plan will be subject to Code section 409A and its many requirements

As this brief post illustrates, taxation of stock and stock based awards is complex, to say the least. Companies exploring equity based compensation arrangements should be sure to understand the tax treatment of any award they propose to issue. Competent tax counsel or a good CPA who is knowledgeable in this area can help.

Footnotes:

¹ Incentive stock options may result in payment of alternative minimum tax.

² A substantial risk of forfeiture may also exist if there is one or more conditions to vesting related to the purpose of the transfer (such as company performance measures). On May 29, 2012, the proposed regulations under Code Section 83 were published discussing and clarifying certain circumstances in which such conditions may or may not result in a substantial risk of forfeiture.