Equity compensation is a form of employee compensation representing an ownership interest in the employer and can take many forms depending on the needs and objectives of the company. Equity compensation is typically non-cash and often paid in the form of stock options or rights. Companies use equity compensation as both a means to align the interests of employees and stockholders and an incentive for employees for future performance. Furthermore, it is generally treated as taxable ordinary income because it is compensation for services performed. Common forms of equity compensation available include restricted stocks, restricted stock units (RSUs), stock appreciation rights (SARs), phantom stocks, and stock options. The following newsletter will provide a detailed discussion of stock options granted by public company employers to employees, specifically addressing tax and regulatory considerations.
Employee Stock Options and Tax Considerations
Employee stock options provide the employee with the right to buy employer stock at a specified exercise price at the end a specified vesting period. The exercise price is typically the fair market value of the share of stock at the time the option is granted and the vesting is typically time based and less often performance based. The options are exercisable for a specified exercise period after the option vests for up to five to ten years. Stock options are classified for tax purposes either as Non-Qualified Stock Options (NQSOs) or Statutory Stock Options (ISOs and ESPPs), whereas the tax treatment for stock options depends on its classification.
Non-Qualified Stock Options
NQSOs require an ordinary income tax payment on the difference between the grant price and price at which you exercise the option, thereby omitting them from special treatment accorded to incentive stock options. The tax treatment for NQSOs is generally not as favorable as statutory stock options. NQSOs can be granted with an exercise price that is less that the fair market value on the grant date (referred to as discount options, or on the exercise of the option, but not on both.
However, this generally causes adverse tax consequences for the option holder under IRC section 409A. IRC section 409A applies to nonqualified deferred compensation covering a broad range of arrangements, including some that are not traditionally thought of as providing for a deferral of compensation, such as discount stock options, Stock Appreciation Rights (SARs), and Restricted Stock Units (RSUs). Any delayed transfer of cash or stock after vesting of equity compensation awards generally results in nonqualified deferred compensation subject to IRC section 409A.
Statutory Stock Options
Statutory stock options include incentive stock options (ISOs) and options granted under employee stock purchase plans (ESPPs). ISOs neither have nondiscrimination or coverage rules for stock option to qualify as ISOs, nor are they subject to ordinary income taxes, provided certain holding requirements are met. At the time of sale, the holder of ISOs is taxed on the difference between the sale price and the exercise price at long-term capital gains rates rather than ordinary income taxes. Yet, if the ISOs shares are sold before the end of the holding period, the option holder recognizes ordinary income, not capital gain, on the difference between the exercise price and the fair market value of the shares on the exercise or sale date. Any additional gain between the date of purchase and the date of sale is taxed at capital gain rates, so long as the capital gain holding periods are met.
ESPPs are a type of stock option plan that allows employees to buy the granting company’s stock or stock of an affiliate at up to a 15% discount. Like ISOs, ESPPs must qualify to receive tax-favorable treatment and there is no tax on the grant or exercise of an option under it. ESPPs also allow employees to elect to make payroll contributions during an offering period that are then used to exercise a certain number of options or purchase rights at the end of the offering period. However the portion treated as ordinary income is less than it would be if the options were a NQSOs.
In addition, statutory stock options are not subject to employment tax (FICA and FUTA).
Companies granting any form of equity compensation must also bear in mind various securities law and US securities exchange requirements and restrictions. Generally securities may not be offered or sold to persons in the US unless a registration statement has been filled with and declared “effective” by the Securities and Exchange Commission (SEC) or there is an exemption from the registration requirements of the Securities Act of 1933. If an employer grants options to its employees under the certain circumstances, the initial stock option grant is generally viewed as not being subject to the registration requirements of the Securities Act. In addition to federal filing requirements, it is also important to consider whether any state filings or other requirements are required under state securities laws, typically referred to as blue sky laws.
Lastly, Excluded from the definition of “equity compensation plans” are arrangements under which employees receive only cash and plans that merely provide a convenient way for employees and other service providers to buy shares on the open market for their current market value.
If you are interested in learning more about stock options and grants and/or how they may affect you, then please contact Larry Horwitz at firstname.lastname@example.org.