Stock-based Compensation Issues

Employee Stock-based Compensation

There are many different methods for compensating employees with equity in the company. We have limited this discussion to Incentive Stock Options (ISOs) and Non-qualified Stock Options (NQSOs), but we have included a list of other types of stock based rewards below.

Incentive Stock Options

Incentive stock options, also known as statutory or qualified options, are a popular form of equity based compensation. Employers must satisfy several requirements to qualify their options as ISOs. One such requirement is that the company foregoes an income tax deduction when it chooses to use ISOs. This is because when an employee exercises an ISO under the guidelines set forth by the IRS, the gain on the shares is not taxed as ordinary income in that year. Therefore, the company may not deduct this income to the employee as compensation expense.

There are several other requirements placed on the employer to qualify its option plan as an ISO. These are as follows: the option grantee must be an employee, the option must be to acquire employer stock, the option plan must be approved by the shareholders, the options must have a ten year maximum duration, the option exercise price must be no lower than the market price on the grant date, the options are non-transferable during the employee’s lifetime, there must be an option vesting limit of $100,000 in any given year, and the options must have a required holding period after exercise. Issues such as these increase the amount of time and effort involved in the administration of these plans, often limiting this compensation strategy to larger corporations.

From the employee’s perspective ISOs can be a good way to build income that is sheltered from regular income taxes. ISOs are designed to receive certain tax breaks under IRS Section 422. As long as the option holder does not exercise his/her option prior to twelve months from the grant date, any spread between the exercise price and the market price is not taxed under the regular tax rules. Furthermore, if the option holder allows an additional twelve months to pass before selling his/her shares (two years from the grant date), any gain on the shares can be taxed as long-term capital gains. With the Tax Reform Acts of 1986, 1993, and 1997, this tax rate is lower than the tax rate on regular income.

Non-qualified Stock Options

Options that do not meet the requirements for ISOs are, by default, non-qualified stock options. Employers generally expect to receive a future tax deduction for employee income, but the amount is not known until the date of exercise, and is based on the stock price at that date. The reporting and general structure requirements for NQSOs are not as stringent as those for ISOs. These factors make the administration of NQSOs somewhat easier than ISOs, and make these plans more likely to be employed by smaller, start-up firms.

From the employee’s perspective non-qualified options do not offer all of the benefits of ISOs. Basically, NQSOs do not receive the same tax treatment as ISOs. Although the granting of these options is typically a non-taxable event, any gains on NQSOs are taxed as ordinary income at the time of exercise. However, the option holder still receives capital gains treatment on the eventual sale once the holding period requirement is met.

Alternative Minimum Tax Issues

While gains in ISOs as of the date of exercise are not taxed as income for ordinary tax purposes, they are considered a “positive adjustment” for the purpose of calculating a potential Alternative Minimum Tax (AMT) liability. The AMT is a separate set of tax rules. In general, it only applies to higher income levels ($75, 000 - $100,000 per year), or those with alternative sources of income in addition to their salaries (rental property, partnerships, stock options, etc.). With AMT, the taxpayer must add back personal and dependent exemption deductions, as well as deductions for state and local taxes, and home equity loan interest. Other itemized deductions such as investment expenses and employee business expenses must also be added back.

These steps basically recalculate the taxpayer’s minimum taxable income. An AMT exemption is then allowed to arrive at the AMT taxable income. Holders of ISOs who exercise in a given year are particularly subject to the AMT and should consult their tax advisor for direction on avoiding or reducing potential exposure to this tax. General examples of ways to avoid or reduce this exposure are exercising sooner rather than later to reduce the overall “exercise-market spread”, and staggering exercise dates to reduce the average spread.

Other Types of Stock-based Compensation

Other types of stock-based compensation are dividend equivalents, stock appreciation rights, “look-back” options, and phantom stock. Each of these plans has its particular advantages based on the circumstances of the firm, its goals, and the mission of the management team for its employees.

Communication Is Key

Once a company has decided upon an option plan, it must ensure that it effectively communicates to the proper regulating bodies and to the participating employees.

A public company must communicate its implementation of a stock option plan to the Securities and Exchange Commission (SEC). The company’s determination of the exercise price is an important factor here. It must ensure that the options are not priced at a level deemed unreasonable when compared to the market value of the company’s equity. This is especially true for ISOs, which as mentioned previously, cannot have an exercise price below the market price at the grant date. Also, quarterly filings with the SEC such as 10Qs, must fairly account for the options or the company faces potential penalties for inaccurate reporting.

Companies utilizing stock options must also comply with the Financial Accounting Standards Board (FASB), which oversees the definition and application of accounting rules for corporations. Under FASB Statement 123, companies are encouraged to use a fair market value standard when recognizing expenses related to stock options for presentation in company financial statements. Adoption of this method is typically accomplished through financial statement footnote disclosure. This is vital to avoid the negative consequences of misrepresentation in the company’s financial reporting.

The Internal Revenue Service (IRS) also regulates certain aspects of a company’s stock option plan. Issues relating the company’s deductions for income tax as well as the tax status of individuals who are exercising their options are of great interest to the IRS. Ensuring early on, and on a continuing basis, that the company’s option plan meets all IRS requirements necessary to maintain a certain tax status, as outlined in the section on ISOs, is critical. Proper administration of all documentation both internally and externally, is also vital to maintain the integrity of the firm’s compensation program.

Finally, the company should communicate not only the company’s goals for the plan to its employees, but also the benefits to the employees as participants in the plan. This is accomplished through early and ongoing education for the employees, as well as disclosing current information on exercise procedures, tax issues, etc. With many high-tech firms, these needs are met easily through the use of electronic communication channels.

Adams Capital is well versed in the types of stock compensation available, particularly those commonly used in the high-tech marketplace. We will work closely with your management team and your legal and financial advisors to assist in structuring the program that best suits your company’s goals and your employees’ needs.

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