By Kenneth H. Bridges, CPA, PFS February 2006
Companies frequently use stock-based compensation plans to attract and retain the best talent. When properly structured, these plans can be very advantageous from a tax and financial accounting perspective. However, when not properly structured, they can be a trap for the unwary. This article describes various types of stock compensation plans and the tax and accounting treatment of such plans.
Stock Grant – Unrestricted Shares – The employer corporation can transfer shares outright to the employee, subject to no restrictions (other than standard right-of-first-refusal restrictions). This gives the employee an immediate equity stake in the company, and it is simple and easy to understand. The employee can pay full fair market value for the shares, pay a discounted amount, or pay nothing at all.
For income tax purposes, the employee has compensation income equal to the excess of the value of the stock over the amount paid (i.e. the “bargain element”). This frequently comes as a surprise to the employee, that he or she has compensation income subject to tax though no cash has been received, and can be a hardship. The employer corporation receives a tax deduction for the amount included in the employee’s income.
The employee receives a tax basis in the shares equal to their value at the time of receipt, and will have capital gain or loss upon a later sale of such shares.
Stock Grant – Restricted Shares – Generally speaking, an employer corporation will not want to make an outright transfer of shares to an employee without some restrictions that tie the employee to the company for a period of time. Generally, a vesting schedule will be used under which the employee’s rights to the stock vest over a period of years or upon the attainment of certain performance goals.
The tax law provides that where stock granted to an employee is subject to such restrictions, the bargain element is included in the employee’s income only as the shares become vested. While at first blush this may sound advantageous, it generally proves to be very detrimental. If the company is successful, then the stock value will be rising, and, accordingly, the compensation amount will be rising also.
Fortunately, the tax law provides an election (known as the “83(b) election”) by which the employee can elect to “lock in” the compensation amount at the date of grant. Unfortunately, this election must be made within 30 days of the date of grant, and the employee frequently does not learn of the availability of such election until it is too late.
Non-qualified Stock Options – An alternative to outright transfer of stock is the granting of an option to acquire shares. Most frequently used are so-called “non-qualified stock options” (NQSOs), which are any options that do not meet the stringent tax law requirements imposed on “qualified” options. The advantages of an NQSO versus a qualified option are the flexibility permitted in the structuring and the fact that the employer corporation will get a deduction equal to the employee’s income upon exercise.
A typical NQSO will permit the employee to acquire a specified number of shares at a future date(s) for a set price. If the value of the company goes up, then the employee will profit. In the meantime, the employee has not been required to make any capital outlay.
Upon exercise of the option, the employee has compensation income equal to the bargain element, and the employer corporation gets a tax deduction in like amount. Because the event of taxation is generally deferred until exercise, the employee has greater control over the timing of the income; and exercise will generally be delayed until the employee is ready to sell some stock so that cash will be available to pay the tax.
Incentive Stock Options – If a stock option plan meets certain tax law requirements, it may be treated as an incentive stock option (ISO) plan, also referred to as a qualified stock option plan. With an ISO, the employee is not taxed until he or she sells the stock, and, if certain holding period requirements are met, will be eligible for long-term capital gains treatment. Conversely, if the holding period requirements are met, the employer corporation receives no tax deduction. This is the tradeoff.
While the general rule, as noted above, is that the employee is not subject to tax until the stock is sold, the employee may be subject to alternative minimum tax upon exercise, depending upon the employee’s particular tax situation.
ISO plans were very popular prior to 1987, because ordinary income rates were substantially higher than the capital gains rate. With the ordinary income rate and capital gains rate being equalized by the 1986 Tax Reform Act, NQSOs became more popular. Then, with the ordinary income rates creeping upward and the capital gains rate being cut during the 1990’s, ISOs once again became popular.
Stock Appreciation Rights and Phantom Stock – If the employer corporation wishes to reward an employee based upon the performance of the company’s stock value but without giving up any actual ownership of the company, then stock appreciation rights (SARs) or phantom stock may be used.
A SAR gives the employee the right to receive cash equal to the appreciated value of the employee’s stock when the right is exercised. SARs are sometimes used in conjunction with an NQSO plan in order that the employee will have cash with which to pay the tax from the exercise of the option.
Similar to a SAR, phantom stock plans typically give the employee the right to a cash payment based upon appreciation in the value of the company’s stock. Typically the employee is also entitled to a cash payment whenever dividends are paid on the stock. Thus the plan mirrors actual ownership of stock.
For tax purposes, the employee generally has compensation income at the time of payment, and the employer is entitled to a tax deduction in like amount.
Internal Revenue Code Section 409A– IRC section 409A was enacted in 2004 to curb perceived abuses in the area of executive nonqualifed deferred compensation (NQDC). The supposed primary target of this legislation was the situation in which corporate executives enjoyed the benefit of tax deferral on deferred compensation, but then wanted to be able to shelter the deferred compensation from the reach of creditors of the employer corporation in the event the employer’s financial health deteriorated (e.g. Enron and Delta). However, the rules as written are quite broad and can cover many more situations; and the ramifications of compensation being subject to 409A are severe.
Section 409A provides that where an NQDC plan fails to meet certain requirements amounts deferred thereunder will be included in taxable income and, in addition to the normal income tax that would apply, will be subjected to an additional 20% tax plus interest accruing from the year that the amounts were deferred.
Stock options are excluded from the reach of 409A, provided that the exercise price can never be less than the fair market value of the underlying stock as of the date of grant. Accordingly, it is very important to document that the strike price is at least as great as the value of the stock at the date of grant. The proposed regulations acknowledge the difficulty in valuing the stock of a privately-held company; particularly illiquid stock of a start-up company. Under the proposed regulations, a valuation of illiquid stock of a start-up company will be presumed to be reasonable if the valuation is made reasonably and in good faith and evidenced by a written report that takes into account the relevant factors prescribed for valuations in the regulations.
Employee Stock Purchase Plans and ESOPs – The stock compensation plans described above are typically offered to only a limited number of key employees. Where broader employee ownership is desired, a company may use an Employee Stock Purchase Plan (ESPP) or an Employee Stock Ownership Plan (ESOP).
The tax treatment of an ESPP is much like that of an ISO plan. However, the ESPP must be made available to a broader class of employees, and the option price can be set as low as 85% of fair market value.
The ESOP is essentially a retirement plan which invests in the stock of the employer corporation, and through which the employees, the corporation, a selling shareholder, and a lending institution financing the ESOP’s purchase of the stock all receive favorable tax treatment.
Limited Liability Companies (LLCs) and Partnerships – The above discussion pertains to corporations (C-corps and S-corps). However, today many businesses conduct their operations through the LLC format, which for income tax purposes is generally treated as a partnership. The rules in this area for partnerships are generally the same; with some important exceptions.
First, a partnership cannot issue ISOs. Only a corporation can issue ISOs. However, the same or better result can typically be achieved with a partnership by use of what is referred to as a “future profits interest”; that is a share of future profits and appreciation, but none of the existing value of the partnership. The result that can be achieved by use of a future profits interest is generally more favorable for the recipient than stock options in that, if properly structured, the recipient’s holding period for long-term capital gains treatment begins to run immediately and there is no alternative minimum tax adjustment like you have with ISOs. Under proposed regulations, the partnership agreement would need to provide for an election to obtain this favorable treatment and, if the interest is subject to vesting, a section 83(b) election would need to be made.
Financial Accounting Rules – Until recently, financial accounting rules for stock-based compensation provided that stock options issued under a fixed plan (i.e., fixed number of shares vesting on fixed dates) resulted in a charge against earnings only to the extent that the exercise price was less than the value of the shares on the date of grant, while stock options issued under a variable plan (i.e., number of shares or exercise price to be determined by subsequent events) could result in a charge to earnings. Under these rules, it was possible to structure stock-based compensation plans to avoid a charge to reported earnings.
In 1993, the Financial Accounting Standards Board (FASB) stirred up quite a controversy by proposing new rules which would have required companies to charge the cost of most stock-option compensation against earnings in their financial statements. After receiving much pressure from high-tech companies, accounting firms, members of Congress, and other groups, FASB backed down from this proposal and instead opted to require footnote disclosure only.
Later, following the bursting of the dot-com bubble and the Enron debacle, the landscape for accounting rule-makers changed and the public was more amenable to the idea that issuance of stock options should result in a charge to financial statement earnings. Under current rules, issued in late 2004, companies are now generally required to calculate the “fair value” of stock options issued to employees and recognize the related expense as a charge to earnings over the period of required service. This means that virtually all forms of stock compensation will result in a charge to earnings, even if there is no “intrinsic value” (i.e. no in-the-money value) at the date of grant.
For plans such as stock appreciation rights or phantom stock where payment is actually made in cash, a charge to earnings is required as the compensation accrues.
Summary – Stock-based compensation plans are an excellent way to attract and retain top talent, while linking the employee’s rewards to the success of the company. When structured and utilized properly, the tax and financial accounting treatment can be very favorable for both employer and employee. The key is for both employer and employee to understand the rules, and plan accordingly.
Kenneth H. Bridges, CPA, PFS is a partner with Bridges & Dunn-Rankin, LLP an Atlanta-based CPA firm.
This article is presented for educational and informational purposes only, and is not intended to constitute legal, tax or accounting advice. The article provides only a very general summary of complex rules. For advice on how these rules may apply to your specific situation, contact a professional tax advisor.