Providing stock to employees is likely to raise their loyalty to the company because, as a stockholder, they have skin in the game and should want to see the company succeed and their investment grow. We provide a general overview of paying employees with stock and discuss the potential tax affects stock based compensation can cause.
According to the National Center for Employee Ownership, in 2010, of the publicly traded companies, 36% of employees own stock in their employers through one type of plan or another. More and more companies are offering stock options to their employees from cash-restricted Silicon Valley startups to conventional manufacturing and service firms that compete for top talent and experienced personnel. However, paying in stock can be complicated for a number of reasons including tax consequences, employment and labor considerations, and effects on the business. For example, while cash is “expensive” in early stage companies, stock can be drastically more expensive once the company becomes profitable. Everyone knows the tales of the Microsoft secretaries that became millionaires after being compensated with stock but, if you ask Bill Gates, he would probably agree that there was no other viable form of compensation available at that time.
There are two types of stock available that can be used to pay employees, venders, service providers, and even the owner of the company. These types are stock grants and stock options.
What is a stock grant?
Stock grants allow the company to provide compensation for goods and/or services by issuing stock. This stock may be awarded outright without restrictions or with restrictions. If the stock carries restrictions, the new owner of the stock may not be allowed to freely trade, sell, or exchange the stock until these restrictions are removed or expire.
Types of restrictions can include vesting, forfeiture, and lock-up agreements. Vesting requires that a certain event take place before limitations on full ownership may be removed. So, for example, stock in company X may not be vested by the employee until they have been with company X for five (5) years. Once the employee reaches his or her fifth anniversary with company X, the stock fully vests and becomes the employees.
Another common restriction placed on stocks provided as compensation is “forfeiture.” Forfeiture can occur when a certain or specified future event occurs (or does not occur, in certain situations) thus allowing the stock to return to the company. As mentioned above, if the employee does not stay with company X for five years and they earn 10,000 shares per year of eligibility (employment), then those shares are forfeited back to the company.
An additional common restriction placed on stock used as compensation is the “lockup agreement.” A lockup agreement is legally binding contract between the issuer and insiders of a company that prohibits the insiders from selling any shares of stock for a specified period of time, hence “locked up.” Company insiders typically include employees and directors, their friends and family, and venture capitalists. The terms of lockup agreements may vary, but most prevent insiders from selling their shares for some specified amount of time or until the company reaches certain goals or benchmarks. Lockups also may limit the number of shares that can be sold over a designated period of time. The restrictions in lockup agreements can be “soft” for example, by allowing a shareholder to terminate if a superior offer is presented or “hard” by being unconditional in nature. U.S. securities laws require a company using a lockup agreement to disclose the terms of the agreement in its registration documents, including its prospectus. Additionally, some states require lockup agreements under their “blue-sky” laws.
What are the tax consequence of a stock grant?
The tax consequence of stock grants can be complicated by the nature of the restriction(s), state law, and whether or not the stock is free-trading when issued. For specific questions regarding the nature of your company’s stock and the tax consequences of issuing the stock, please consult an experienced tax attorney or we can provide you with the names of trusted tax attorneys.
For the recipient of the stock. The United States Internal Revenue Service (“IRS”) treats payments made in stock as the equivalent to those made in cash. Thus, a payment of stock requires the receiver to report it as income and pay taxes in the same manner as if the transaction occurred in cash. When the recipient of the stock has to pay the taxes is complicated because it depends on whether the stock was given outright without restrictions or not. If the stock was given without restrictions, then the income will have to be reported and taxed when received.
If the stock has restrictions, then the income will have to be reported when those restrictions no longer exist. Or, the recipient of the stock can file a Section 83(b) election with the IRS, which allows the stock to be presently taxed. This is important and an underutilized tool because taxes are paid at a “fair market value” of the stock price and by using a Section 83(b) election the shares can be taxed at the “present” fair market value and allows for further taxation on the stock to be via a capital gains rate. The IRS considers fair market value to be the trading price if the stocks trade on the open market or if the stock does not trade, then the recent cash sale prices are used to determine the fair market value. There are potential reductions from this fair market value assessment made by the IRS and can include citing factors such as the restrictions on the stock such as a lockup agreement or the illiquidity of the trading market for the stock. This type of rebuttal requires input and advice from your tax advisor or attorney. It is important to also note whether the stock is vested or, if any, forfeiture dates have been met to determine when to you are required to pay taxes.
For the company issuing the stock. The IRS requires a company record expenses on its financial statements in the amount equal to fair market value of the stock paid as compensation. This could significantly reduce or, in some cases, eliminate all of the company’s reported earnings for that tax year. What will not likely reduce or eliminate the company’s amount of reported income is if there are restrictions or other factors that limit the liquidity of the stock.
What is a stock option?
A stock option is a securities mechanism were stock is not received by the potential recipient until he or she acts on that right or option. Stock options often require certain conditions to be met before a potential recipient can exercise the option and can specify a certain price or terms if exercised. There are two types of stock options incentive stock options (“ISO”) and non-qualified stock options (“NSO”).
ISO plans are more common than NSO plans but can only be granted to employees. There are also a number of tax requirements to fulfill the ISO status including:
- The option price must be at least the fair market value of the stock at the time of the grant.
- The option cannot be transferable, except at death of recipient.
- The options must be granted within the earlier of ten (10) years of the plan or approval of the plan.
- The employee cannot have an option over $100,000 dollars of the aggregate fair market value (determined at the granting time) during any calendar year (excess treated as NSO).
- The option must be exercised within three (3) months of termination of employment with the company (one year for disability; no limit in case of death).
ISO plans have many conditions relating to their issuance including an aggregate number of shares that may be issued, a time limit to exercise the option, non-transferability, a specific amount that can be exercised each year, stockholder approval, and restrictions on the exercise price (this could require that the fair market value of the stock option be paid on exercise).
NSO are called non-qualified stock options because they do not meet all of the requirements of the Internal Revenue Code to be qualified as ISOs but they are simpler than ISO and can be granted to anyone including employees, consultants, and directors of the company.
Stock options have a different tax implications depending on the nature of the stock and its restrictions or the option and the prices and terms. Stock options do not eliminate the tax problems of using stock as compensation but instead, delay the reporting of income and taxation.
What are the tax consequence of a stock option?
The tax consequence of stock options can be complicated by the nature of when the stock became income. For specific questions regarding the nature of your company’s stock and the tax consequences of issuing the stock, please consult an experienced tax attorney or we can provide you with the names of trusted tax attorneys.
For the recipient of the stock.Tax implications for stock options vary greatly depending on whether the option is a ISO or NSO. If the option is an ISO then no regular federal income tax is recognized upon the exercising of the ISO stock option. An NSO, on the other hand, triggers ordinary income tax at the fair market value, if any, of the shares on the date exercise over the exercise price. The most important tax implication of an NSO, is that they are subject to taxation on vesting and the tax penalty under IRS Section 409A needs respected because it could cost the recipient the current year and all previous years of taxable income, plus a 20% penalty tax.
Employees exercising NSO are subject to tax withholding. While ISO employees may be subject to the dreaded alternative minimum tax (“AMT”). For example, an employee receive ISOs to buy 100 shares at the current market price of $1 per share. Then, one year later, when shares are worth $2, and the employee exercises his or her option thus only paying $1. The $1 difference between the exercise price and the current $2 market value is subject to AMT. How much AMT will the employee pay depends on the income and deductions for that employee. For taxable income up to $179,500 dollars or less (2013), the AMT rate is 26% and 28% for income above $179,500 dollars. This means the employee who exercised his or her ISO option to purchase stock at $1 when the market value was at $2, must now pay, depending on applicable deductions, an AMT of .26¢ cents or .28¢ cents per share, respectively. However, if the shares of an ISO are held for more than one year after the date of exercise of the ISO and more than two years after the date of the grant of the ISO, any gains or losses on the sale or other disposition will be taxed under long-term capital gains rate (currently, 15%). Additionally, the employee could sell the stock for a profit and may be able to recover the AMT through an “AMT credit” unless the stock falls before the employee sells and then he or she could be stuck paying a large AMT tax bill on “phantom income.” Phantom income is money that employee has to pay taxes on but no longer has because the stock was sold at a loss.
Also, an earlier sale or other disposition (a “disqualifying disposition”) will cause the option to be treated as an NSO. This will result in ordinary income tax on the excess, if any, of the lesser of the fair market value of the shares on the date of exercise or of the proceeds from the sale or other disposition, over the purchase price.
For the company issuing the stock. There are benefits and complications to offering stock options to employees and service providers beyond recruiting and retaining talent. One of the most recognized benefits, is that a company may generally take a deduction for the compensation deemed paid upon exercise of an NSO. Similarly, a company may take a deduction if an employee has a disqualifying disposition of shares he or she exercised as an ISO. However, if a potential recipient holds an ISO for the full statutory holding period, then the company will not then be entitled to a tax deduction.
Stock options pose a significant undertaking by U.S. Securities and Exchange Commission (“SEC”) reporting companies because the company must separately calculate the value of each option per quarter and must record the amount as a non-cash expense. Another issue for SEC reporting companies is that issued stock cannot be immediately resold but requires taxes to be paid. So, stock received in a stock based compensation program for a reporting company is treated by the SEC as restricted just as it would be in a private placement under Rule 144. However, the SEC provides partial relief to this problem by permitting a short form, non-reviewed registration statement under the Securities Act of 1933, as amended on Form S-8. The SEC does not treat stock received under an S-8 registration statement as restricted stock. It is important to note that not all forms of service can be paid with S-8 stock and that officers, directors, and affiliates do not receive fully free trading stock. The holding period under Rule 144 is eliminated but the remainder of the resale restrictions under Rule 144 are still applicable because the securities are now considered controlled securities.
This securities law blog post about going public is provided as a general informational service to clients and friends of Feinstein Law, PA and should not be construed as, and does not constitute, legal and compliance advice on any specific matter, nor does this message create an attorney-client relationship.
For more information concerning the rules and regulations affecting the going public direct transactions and direct public offerings please contact Feinstein Law, PA at (619) 990-7491 or by email at Todd@Feinsteinlawfirm.com or JDunsmoor@Feinsteinlawfirm.com. Please note that the prior results discussed herein do not guarantee similar outcomes.
