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Does your company need a stock option plan? The answer to this question involves three main areas of justification. Thus, to answer the question, you must necessarily find advantage in one or more areas of such justification for a stock option plan. A stock option plan can be used to attract or retain highly qualified managers and employees, create incentives for managers and employees to increase performance and help coordinate the interests of managers and employees with those of the management and stockholders of the company. Most companies in Colorado Springs and in the high-tech area use stock option plans to recruit and keep talented executives, management and employees. Stock option plans are not limited to large public companies. Stock option plans allow small companies to compete with the larger public corporations in hiring and keeping talented individuals that they might not otherwise be able to entice with sufficient salary incentives. Thus, stock option plans have become an attractive vehicle of compensation for companies because of their favorable accounting treatment and preferred tax status. Stock options are also used to compensate employees as "pay for performance." Stock options can be designed to enhance executives' and employees' performance because an option's value is based in part on the company's stock price exceeding the exercise price of the option. Thus, stock options can create financial incentives for executives and other employees to work to get stock prices up. Creating a clear link between a company's stock price and the executives' or employees' performance, will dramatically increase the motivation of the respective employee as it relates to their incentive to enhance the company's overall performance. Recently, institutional investors have advocated the use of pay for performance on these grounds because of these motivational factors. Stock option plans provide managers and employees with an ownership interest in the company. Thus, stock options help align managers' interests with those of shareholders. Many stock analyst claim that stock-based pay is superior to other fixed components of compensation, such as salary and bonuses, because stock options reward managers and employees alike for thinking like shareholders. Risk Justification Stock options can be used to motivate employees and managers to take justified risks. That is, managers and shareholders exhibit different degrees of risk aversion. Managers are invested in the corporations that they manage through their jobs and risk their salaries if the corporation becomes insolvent. Executive salaries are usually based exclusively on the value of the corporation's shares and whose value declines if the firm's value fluctuates substantially. A manager's value and human capital may decline if the company takes risks that do not payoff. The success or failure of a project proposed by an executive will reflect directly on that executive. Outcomes that reduce the value of the corporation ultimately injure the executive's future earnings. These factors combined, lead managers to be risk-averse in their corporate decision-making because managers gain little if the company does well and they have much to lose if it does poorly. Stock options are unique, in that, stock options reward success and do not penalize failure. Thus, this payoff feature helps to enhance the positive returns for executives and management implementation of projects that rewards shareholders with higher stock values. Special Tax Treatment The main advantage to offering employee stock options plans is the special treatment they receive under the Internal Revenue Code, statutory "incentive" stock options and employee stock purchase plans. The IRS rules provide that there is no recognition of income on option grant or on the exercise of the option under either of these programs for employee ownership. There is a third type of stock option, the non-statutory stock option, however, the IRS rules are not as favorable and require the inclusion of the option's or stock's fair market value as ordinary income in the tax year of the grant. There are penalties to incentive and stock purchase plans. What is the main tax advantage to incentive or stock purchase plans? Simply put, after an employee holds the stock for the required statutory holding period, any appreciation on the sale of the underlying shares will be taxed as capital gain (currently 20%) and not at his/her ordinary income tax rate (which could be as high as 39.6%). There are pitfalls that the business owner and board of directors should be aware of before granting an option to an executive or employee. Should a company grant stock options or other equity-based compensation to employees before adopting a proper stock option plan risk losing significant tax benefits and imposing unexpected tax liability on their key employees. Under IRS Code Section 83, employees who receive property, including stock options (non-statutory stock options), in exchange for services are taxed at the time the employee exercises the option, rather than at the time the employee receives it. The tax is assessed at ordinary income rates (which can be as high as 39.6%) on the difference between the fair market value of the underlying stock on the date of exercise and the exercise price of the option. This tax is due and payable whether or not the employee sells the stock received on exercising the option. This is the tax result of a non-statutory stock option. Thus, if favorable tax treatment is desired, a property stock option plan should be in place before the grant of any option and the appropriate holding period requisites should be adhered to by the employee. The bottom line for a company that adopts a qualified incentive stock option plan is that the company can provide a way to reduce the tax burden of options on themselves and their employees because incentive stock options permit an employee to postpone recognizing income on exercising options until the time the employee actually sells the underlying stock. By postponing taxation of that income, a qualified incentive stock option relieves the employee of the need to find the cash necessary to pay taxes on the stock appreciation until the time the employee actually sells the stock and has the cash available to pay the tax. Usually, this occurs on a merger, acquisition or initial public offering of a company.
ISO plans do have some limitations relating to the Alternative Minimum Tax rules. In certain very high growth situations, the alternative minimum tax liability that incentive stock options can impose on option recipients may make their use undesirable. However, regardless of the AMT tax problem, for most burgeoning technology companies, the benefits of a properly adopted and implemented an incentive stock option plan far outweigh any AMT tax disadvantages both for the company and its key employees. Rules for a Qualified Incentive Stock Option Plan The rules for a qualified incentive stock option must be followed to receive the special deferral tax treatment under the IRS Rules and Regulations. Thus, before an employee may sell the shares of stock underlying an incentive stock option, an employee must hold the stock for at least one year following the exercise of any incentive option and may not sell the shares for two years following the date of the option grant. The employee's entire gain on the sale (the sales proceeds of the stock less the exercise price of the option) will be taxed at capital gains rates (currently 20%). If an employee violates these holding period rules, the difference between the fair market value on the date the option was exercised and the exercise price will be taxed as ordinary income, with any balance taxed as capital gain. Generally, ISO plans must:
What is a Non-statutory Stock Option Plan Non-statutory stock option plans are any plan that does not meet the requisites of a statutory stock option plan. Thus, if your stock option plan does not meet the rules of a statutory plan, the plan is by default a non-statutory stock option plan. A non-statutory stock option is taxed to the employee at the date of the grant, but only if the option has a readily ascertainable fair market value at such time (most stocks do not have readily ascertainable fair market value unless publicly traded). Thus, if the option does not have a readily ascertainable value at grant, it is taxed at the time of exercise. The employer has a corresponding income tax compensation deduction at the time of exercise. Generally, non-statutory stock options are structured to provide key employees the right to purchase a certain number of shares of stock at a predetermined price at some point in the future or at any time or upon the occurrence of an event (like a target profit or sales projection). Most small companies' stock options are not readily tradable on any market, thus, their value is hard to determine. The IRS Rules and Regulations create an irrebuttable presumption that an untraded option does not have a readily ascertainable fair market value unless four conditions are met:
Therefore, placing the above restrictions on an option that is otherwise not available for trade on a recognized market will cause such option to be deemed not to have a readily ascertainable fair market value.
An employee receiving restricted stock may elect to have the ordinary income element of the restricted property close at the time the property is transferred. Closing the taxable event under Code section 83 gives the employee the opportunity to limit the employee's ordinary income from the transaction to any spread on the date the property is transferred between the fair market value and the amount paid for the property. Any appreciation in property after the date of the transfer is potential capital gain income which will be recognized when the property is disposed of by the employee. The IRS Code section 83(b) election must be made within 30 days after the transfer of the property; and once the election is made, it is irrevocable, unless the IRS agrees to the revocation. The election is not without risk. If an employee makes the election and recognizes ordinary income and the property is thereafter forfeited pursuant to the restrictions, no deduction is available to the employee. However, this risk is small compared to the failure to make a timely election under Code section 83(b), "the Code Section 83(b) Trap," which will cause the entire gain to be taxed as ordinary income rather than capital gains. Conclusion Employee moral is an important component in any company's overall business management plan. As such, a properly instituted employee stock option plan, whether statutory "incentive" or non-statutory, can enhance the overall business plan of the company through encouraging risk taking that is advantageous to the company and provide a vehicle to retain key employees. This is especially true in most high-tech start up companies but may also be the case in many so-called "old economy" small businesses as well. One plan is not suitable for all employees. Thus, the proper strategy is to match the type of plan with the mix of employees at you company to encourage the type of growth and/or stability that benefits the company. Like other areas of tax law, this area is filled with pitfalls and attention to detail is important. Thus, implementation is key to providing employees with the proper vehicle to share in equity ownership and realize the dream of enjoying the fruits of their labors at some point in the future without unnecessary tax burdens. Contact the author if you would like to discuss implementing a stock option plan for your company. Copyright © 2000, ScrantonPC.com |