Introduction to the Advantages and Disadvantages to Stock Compensation Plans
Employers use various compensation methods to motivate and reward employees. Selecting the appropriate method requires an analysis of the costs and benefits in relation to the various tax and securities laws governing such methods. Many start-up companies find it advantageous to use equity compensation. The following are the primary benefits of using stock to compensate employees:
- Gives employees incentive to be productive by giving them stake in company’s success.
- Allows employee to defer recognition of income and gain the benefit of taxation at capital gains rates.
- Addition of restrictions in stock plans can create “golden handcuffs” on various “key” employees.
- Allows company to conserve cash needed to fuel its growth.
The type of entity through which the business is operated will also have a substantial effect on the legal issues involved. Most importantly, many of the tax advantages that are otherwise available through a deferred compensation plan may be restricted for limited liability companies (LLC’s), or S corporations. Consequently, prior to the implementation of a plan, an employer should always be counseled by an attorney and/or tax specialist on the legal aspects and consequences of the plan chosen.
Stock compensation comes in various forms. Employers have the option of using stock to compensate their employees during the employee’s service with the company and/or during the employee’s retirement or at death, i.e., deferred compensation.
Stock Option Plans Used to Compensate Employees During Employment
One of the most common methods of stock compensation is the stock option. A stock option is a contract that allows the holder to purchase a specified amount of stock at a specified price within a specified time period. The advantage is that even if the market value of the stock rises, the holder of the option may purchase the stock at the lower price set by the option contract. However, the primary disadvantage of stock option plans (and stock compensation plans in general) is the dilution of share ownership.
“Qualified stock plans” are arrangements under which the employer grants the employee stock or a stock option in the employer corporation. If these plans meet various statutory requirements found in the Internal Revenue Code, they become “qualified” for special tax treatment. However, if the stock compensation plan does not meet these requirements, then they are termed “nonqualified” plans.
Employers typically use two types of plans to compensate employees during employment: a “qualified” stock compensation plan (“ISO”) and the “nonqualified” stock compensation plan (“NQSO”).
“QUALIFIED” Incentive Stock Options I.R.C § 422
An Incentive Stock Option is simply a stock option granted by employers to employees that meets various statutory requirements, thereby entitling participant employees to extremely beneficial tax treatment. In order to receive the tax benefits of a qualified incentive stock option, the following requirements must be met: The employee may not dispose of the stock within two years from the date the option was granted or within one year from the date the employee exercised the option (the “holding requirement”), and the individual must remain an employee of the granting corporation, or its parent or subsidiary, continuously from the date the option was granted until three months before the option is exercised.
Other requirements for the implementation of an ISO include: Such stock options must be granted pursuant to a pre-determined plan stating the aggregate number of shares that may be issued pursuant to options under the plan and the employees eligible to receive the options; Such stock options must have an option exercise price that is greater or equal to the fair market value of the stock at the time the option is granted and; The fair market value of stock issuable with respect to all ISOs that are exercisable for the first time in any calendar year cannot exceed $100,000.
The combination of tax deferral and the favorable long-term capital gains rate makes the use of ISOs a valuable vehicle for equity compensation. Specifically an employee participating in an ISO will gain the following advantages:
- Employee incurs no income on receipt of option.
- Employee incurs no income when he or she exercises the option.
- Employee is only taxed when he or she finally sells or otherwise transfers the stock shares that were purchased pursuant to the option. More importantly, the gain recognized upon this transfer will be classified as long-term capital gain and therefore taxed at only 20%, as opposed to the individual income tax rate which can be as high as 39.6%! Furthermore, gains on shares acquired with options granted after the year 2000 will be taxed at a top rate of 18 percent if shares are held for at least five (5) years.
However, an ISO also has three major disadvantages:
- Employer is not allowed business expense deduction unless employee fails to satisfy holding period requirements.
- Even though employee will recognize no taxable income until stock is disposed of, he or she may be subject to Alternative Minimum Tax.
- The ISO must satisfy rigid statutory requirements, otherwise various tax benefits will not apply.
“NONQUALIFIED” Stock Option Plans (“NQSO”)
A “Nonqualified Stock Plan” is any type of employee compensation method or stock option that does not meet the statutory requirements applicable to the “qualified” stock options discussed above. For example, the direct transfer of stock to an employee as compensation for the employee’s services would be considered a “nonqualified” stock plan. In other words, when a plan is referred to as “nonqualified,” it is referring to the fact that there is no Internal Revenue Code provision granting the plan favorable tax treatment.
Advantages over the “QUALIFIED” ISO:
- NQSO does not have to meet statutory requirements applicable to ISO. Consequently, NQSO is much more flexible than ISO.
- NQSOs can be issued to non-employees, such as independent contractors, consultants, and members of the board of directors whereas ISO can only be issued to employees in order to qualify for beneficial tax treatment.
- The NQSO has no minimum holding period. No requirement that stock options be granted pursuant to pre-determined plan.
- Amount of stock that can be subject to such an option is unlimited.
- Most importantly, employer receives tax deduction for value of the stock bonus taxable to employee.
Disadvantages of the NQSO
The primary disadvantage of the NQSO is that taxable income is recognized by the employee on exercise of the option. The granting of a stock option is not a taxable event unless the option has a “readily ascertainable fair market value” at the time it is granted. Due to the fact that stock options rarely have a “readily ascertainable fair market value,” taxable income is not usually recognized until the option is exercised or disposed of. The income recognized on exercise or disposal of the option is equal to the excess, if any, of the then value of the shares over the exercise price.
Qualified Stock-Based Retirement and Death Plans
Employers also have the option of using stock as a retirement, disability, or death benefit for employees. “Qualified” retirement plans are some of the most important vehicles used in gaining long term tax advantages for employers and employees. In the areas of death and retirement benefits, most employers opt to use various types of “Qualified Defined Contribution Plans.”
How Do Qualified Defined Contribution Plans Work?
All qualified defined contribution plans work in a similar fashion. The employer makes contributions on behalf of the employee participants according to a defined plan providing a definite predetermined formula for allocating the contributions among employee participants. The plan may also allow contributions from its employee participants. These contributions are then made to a trust fund or custodial account. Funds are subsequently distributed to the participants upon a stated date or upon the prior occurrence of some other event (for example, death, retirement or disability). Two of the most commonly used examples of qualified defined contribution plans include: the qualified stock bonus plan and employee stock ownership plans (“ESOP”). These plans are very similar in most respects except that the ESOP is designed to only invest in the stock of the employer, instead of investing in the stock of other corporations. However, employers tend to favor the ESOP because:
- ESOPs are exempt from prohibitions on certain types of transactions that apply to stock bonus plans and other qualified plans.
- ESOP may borrow money to purchase the shares from a party in interest or from insurance companies, banks, and other commercial lenders. Therefore, outside leveraging is an important vehicle in which to finance the stock purchase.
Tax Advantages of Qualified Defined Contribution Plans
Various significant tax benefits are available for qualified defined contribution plans. Contributions made by the employer to the plans are deductible by the employer. As to employees, taxation of income received by participants or their beneficiaries is deferred until the funds are actually distributed, generally at death or retirement. In addition, income received by the employee participant or his or her beneficiaries may be eligible for favorable tax treatment, if the distribution qualifies as a lump-sum distribution. However, even when the distributions are made in the form of an annuity, distributions made during the participants retirement years are likely to be taxed at a lower rate than at the time of contribution due to the fact that most retirees have a lower income and income tax bracket.
As you can see, the earnings that accumulate under the qualified defined contribution plans are tax free until distribution. This not only allows for a tax-free accumulation of earnings, but also protects the participant from being raised into a higher tax bracket during the accumulation of these earnings.
Non-Tax Benefits of a Qualified Defined Contribution Plan
In addition to tax benefits, qualified defined contribution plans also provide an employer with the following benefits and advantages: There are two primary reasons employers choose a qualified defined contribution plan:
- Although the plan must be a “defined” contribution plan, it is still flexible in that it need not specify an exact dollar amount to be contributed every year.
- Once employer has made contributions to the plan, it usually has no further responsibility to the plan or its participants. Therefore, defined contribution plans put investment risk on plan participants, rather than on employer. However, the primary disadvantage is that due to the employer’s discretion as to contribution amounts, the funding of an adequate retirement plan for elder employees may be difficult to achieve under this type of plan.
However, the primary disadvantage is that due to the employer’s discretion as to contribution amounts, the funding of an adequate retirement plan for elder employees may be difficult to achieve under this type of plan.
Often times an employer will want to use compensation other than stock when stock is either unavailable or cumbersome or when the dilution of share ownership is not an attractive alternative. Consequently, many employers have turned to the use of equity substitutes which allows the employer to forgo the actual use of stock as compensation while retaining the employee’s stake in the productivity of the company by creating incentive directly tied to the stock’s market value. The two most commonly use forms of equity substitutes are: stock appreciation rights and phantom stock.
Stock Appreciation Rights (“SAR”)
A stock appreciation right is the right to receive when exercised an amount equal to the appreciation of a given quantity of shares of the company stock over the value of such stock on the grant date. The right to exercise these rights typically vests over a period of time based on employment service. When the employee exercises this right, the appreciation in the hypothetical shares is usually paid in cash, but can also be paid actual company stock having a fair market value equal to the appreciation.
A nontransferable SAR is not generally taxable until exercised. Once exercised, the employee recognizes income in the amount of the payment received. If payment is made in cash, then it is taxed as ordinary income to the employee.
However if payment is made in stock, it is taxable as a nonqualified stock option plan. The advantage to this plan is that the employee has incentive to make the company do well due to the fact that the employee has a stake in the market value of the company’s stock. Furthermore, as indicated above, the employer can use this plan when equity is either unavailable or cumbersome or when the dilution of share ownership is not an attractive alternative. However, SARs are typically satisfied in cash and consequently, are not common with start-up companies.
Phantom stock is basically unfunded deferred compensation based on the company’s stock performance. It may take different forms. For example, the phantom stock may take the form of allocating to an employee the full value of a hypothetical share of stock and all of its economic attributes. Alternatively, it may represent the appreciation from current fair market value, similar to the stock appreciation rights discussed above. Similar to other employee deferred compensation plans, the participant is generally taxed on the benefits when they become payable or, as with the stock appreciation rights, when the exercise of the right to payment occurs.
Various types of restrictions can be placed in these types of plans. Such restrictions usually come in the form of requiring a specified length of employment in order for the benefits to vest or accrue. The result is that the employee has the incentive to stay with the same company in order to receive the benefits of his compensation.
Remember, some of the compensation plans discussed in this article involve the sale of securities by an issuer (stock options for example), and therefore must comply with both federal and state securities laws. Under federal law, the offer or sale of a security must be registered with the Securities and Exchange Commission unless of course the security or transaction is exempt. See 15 U.S.C. § 77. In California, an offer or sale of securities must be “qualified” with the Commissioner of Corporations, except when the security or the transaction is exempt from qualification. See Cal. Corp. Code §§ 25110, 25120, 25130. Consequently, prior to the implementation of a stock compensation plan, an attorney specializing in Security Law should be consulted.
However, if the employee does not satisfy the holding period requirements, then the employee must report the gain as ordinary income and the employer receives a business expense equal to the amount of income reported by the employee. In fact, many employers often enjoy this tax deduction because many employees fail to satisfy the ISO holding periods necessary to “qualify” the plan.
This is because the excess of the value of the shares on the date of exercising the option over their option price is included in calculating a taxpayer’s alternative minimum taxable income.
However, this rule will not apply if the shares purchases pursuant to the option are subject to a “substantial risk of forfeiture.” A substantial risk of forfeiture can, for example, occur when an employee must contractually sell his shares back to the corporation upon the employees termination. In this case income will not be recognized until this risk of forfeiture is extinguished or unless the employee makes an IRS election to recognize gain immediately.
For example, unlike the qualified stock bonus plan, an ESOP may invest exclusively in the employer’s own securities and need not diversify its holdings. There are some limitations imposed on this deduction. I.R.C. § 404(a). This gives employer discretion over how much is contributed to the plan. The plan must only set forth a general formula to be used in determining contributions. For example, it can provide that each year, the board of directors will vote (at its discretion) to make an annual contribution to the plan. Consequently, the participants are not promised a specified amount of deferred compensation, but are entitled to only the benefit that can be provided from their accounts at the time their accounts are distributed. Except for ERISA’s fiduciary requirements. See I.R.C. § 414(i); 29 U.S.C. §§ 1081-1086. See discussion of NQSOs above.