"ARM" yourself to attract, retain and motivate
As an initial matter, companies usually grant equity awards in one of two forms: appreciation awards or full-value awards. An appreciation award, such as a stock option or a stock appreciation right (each described below), gives the employee value only if the company’s stock price increases over a specified amount (usually the fair market value at the time of grant). By contrast, a full value award, such as restricted stock or phantom stock (each described below), has an intrinsic value and provides the employee with the full value of the award upon grant. Importantly, both types of awards typically require a period of service and/or the achievement of specified performance conditions before the employee earns the award (these types of restrictions are usually called “vesting” and are a critical component of any equity program).
Below is a high-level summary of some of the features of the most common types of equity-based incentive awards. While owners often focus on the economic aspects of the various forms of equity awards, the tax impact of each type of award can have a dramatic bearing on the ultimate value provided to employees. As a result, the general tax consequences to employees are described in some detail, as the tax consequences often drive the form of equity award chosen.
Stock OptionsA stock option is a contract that gives the employee the right to purchase a specific number of shares of a company at a fixed price, also known as the “exercise price.” Stock options come in two varieties: nonqualified stock options and incentive stock options (ISOs). While the term “incentive” may lead owners towards choosing “incentive” stock options, both nonqualified stock options and ISOs are incentive-based options. The difference between nonqualified stock options and ISOs is that ISOs are tax qualified options that must be granted and administered in accordance with specific sections of the Internal Revenue Code. Nonqualified options, by contrast, have more flexibility and can have terms that cannot be included in ISOs. Both types of options, however, provide the employee with value if the company’s stock price increases over the exercise price.
From a tax perspective, there is generally no tax upon grant of either a nonqualified stock option or an ISO. Upon exercise of a nonqualified stock option, the employee will be subject to ordinary income tax on the difference between the exercise price and the fair market value on the date of exercise (called the “spread”). With respect to an ISO, however, no tax will generally be due upon exercise. Subject to certain conditions, shares acquired upon the exercise of either type of option should be eligible for capital gains treatment (in the case of nonqualified stock option, capital gains treatment will apply to gain over the value of the stock upon exercise).
Stock option example: Employee receives a nonqualified stock option to purchase 100 shares of Company stock with an exercise price of $1. If the stock price goes up to $15, Employee can exercise the option to purchase 100 shares for only $100, even though the value of the stock is worth $1,500. In order to exercise the option, Employee will have to pay the Company the $100 exercise price (usually in cash). Upon exercise, Employee will be subject to ordinary income tax on the $1,400 spread (the $1,500 value minus the $100 exercise price paid to acquire the shares).
Stock Appreciation RightsA stock appreciation right (SAR) allows an employee to receive cash or stock equal to the appreciation in the value of a share of company stock. The value of a SAR is typically based upon the difference between a stated per share price, also called the “base price,” over the value of the company’s stock on the date of exercise. By contrast to a stock option, the holder of a SAR is not required to pay an exercise price to exercise the SAR.
There is generally no tax upon the grant of a SAR. Upon exercise of the SAR, the employee will be subject to income tax on the difference between the base price and the fair market value of the company’s stock on the date of exercise.
SAR example: Employee receives a SAR to purchase 100 shares of Company stock with a base price of $1. If the stock price goes up to $15, Employee can exercise the SAR and receive cash or stock with a value equal to $1,400 ($1,500 value minus $100 base price). In order to exercise the SAR, Employee will not have to pay a base price (unlike with an option). Upon exercise, Employee will be subject to ordinary income tax on the $1,400 spread.
Profits InterestsA profits interest is grant of an actual partnership interest that entitles the employee to profits realized above a specified “threshold” value, which is generally the value of the company on the date of grant. Economically, profits interests are identical to options, except employees are not generally required to pay an exercise price to receive the underlying equity. Notably, a profits interest can only be granted by any entity that is treated as a partnership for U.S. federal income tax purposes, such as a limited liability company. Importantly, a profits interest is an actual partnership interest and therefore has all the rights and obligations that stem from having an ownership interest in the partnership. Under guidance in effect as of the date of publication of this article, employees should not be subject to tax upon grant or vesting of a profits interest award.
Profits interest example: Employee receives a profits interest in Company entitling Employee to 5 percent of the appreciation of the Company above a threshold amount of $1,000. If the Company is sold for $15,000 Employee would receive $700 or 5 percent of $14,000 (5 percent of the excess of the $15,000 sales price over the $1,000 threshold amount). Employee should be eligible for capital gains treatment on the $700 of proceeds.
Restricted StockRestricted stock is an actual grant of stock in a company that is subject to specified restrictions. Upon a grant of restricted stock, the employee becomes the owner of the stock and will generally obtain the rights of a stockholder, such as voting and dividend rights. The employee, however, will forfeit the shares granted in the event the specified restrictions contained in the grant are not met.
Unless an 83(b) election (described below) is made, the employee will not be taxed upon grant. Rather, the employee will be subject to tax in the year that the restrictions on the restricted stock lapse (i.e., upon vesting) based on the fair market value of the shares on the date of vesting. If an 83(b) election is filed within 30 days of grant, however, the employee would recognize ordinary income on the date of grant based on the fair market value of the shares on the grant date, but would not be subject to additional tax when the shares vest. While the mechanics of the 83(b) election are outside the scope of this article, the availability of the 83(b) election may make restricted stock the most desirable form of equity award under certain conditions, particularly if the company is in its early stages.
Restricted stock example: Company grants Employee 100 shares of restricted stock when the value is $1 per share. The shares will be forfeited if Employee is not employed on the second anniversary of the grant date. The value on the second anniversary is $3. On the date of grant, Employee is deemed the holder of record of the 100 shares of stock. From a tax perspective, however, unless Employee makes an 83(b) election, Employee will be subject to tax on the second anniversary of the date of grant when the shares are no longer subject to a risk of forfeiture. That is, Employee will be subject to $300 of income at ordinary income rates on the second anniversary of grant. By contrast, if Employee filed an 83(b) election, Employee would be subject to $100 of ordinary income on the date of grant, but would not be subject to further taxation when the shares vest on the second anniversary.
Phantom StockPhantom stock is a right to receive a defined value or number of shares based upon the achievement of specified criteria. Typically, phantom stock programs are structured so that the phantom stock tracks the value of the actual stock of the Company. By contrast to restricted stock, however, phantom stock does not represent an actual ownership interest in the company or the underlying shares. Typically, holders of phantom stock are not entitled to the rights of a stockholder, such as voting or dividend rights. While phantom stock can provide companies with flexibility in structuring their compensation arrangements, particularly since the award does not represent an actual equity interest, there are numerous complicated tax considerations that must be taken into account when adopting a phantom stock program. Failure to properly account for these tax code provisions could even result in the imposition of a 20% excise tax on the company’s employees and penalties on the company.
Phantom stock example: Company grants Employee 100 shares of phantom stock when the value of Company’s stock is $1 per share. Employee will vest in the shares of phantom stock if Employee is employed on the second anniversary of the grant date and the phantom stock will pay out on the date that the Company is sold. The value of the stock on the second anniversary is $3 and the value of the stock on the date of a Company sale is $5. Upon the date of grant, Employee has no rights as a shareholder in Company. Similarly, Employee has no rights as a shareholder on the second anniversary when the phantom stock vests. Employee also is not subject to regular income tax on the second anniversary upon vesting. On the date of the Company sale, Employee will receive $500 of cash in settlement of the phantom stock and will be taxed at ordinary income rates.
Small businesses owners should review and understand the various types of equity-based incentive awards available and implement a program tailored to their needs. As a result of the potentially significant tax and securities law considerations, owners should work with their counsel when considering an equity-based incentive program to ensure that the program meets the needs of both the company and its employees. If implemented properly, companies should be able to attract, retain and motivate employees and “arm” themselves with the tools for success.
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