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Stock Options: The Rockstar of Employee Perks

By Parav Patel Email By Parav Patel
February 2023
Stock Options: The Rockstar of Employee Perks

The many ways of offering this valuable employee benefit.

In the dynamic world of running businesses, the key to attracting and retaining top talent is stock options! They offer a backstage pass to company ownership. In the U.S., there are two headliners: incentive stock options (ISOs) and non-qualified stock options (NSOs).

Incentive Stock Options (ISOs)

The Incentive Stock Options (ISOs) allow employees to defer taxation on the option from the exercise date until the sale of underlying shares. However, specific requirements must be met for ISO treatment, including restrictions on stock sale timing, grant limits, and having a fair market value associated with the stock option grant and conversion to shares. If the rules are followed, employees can enjoy longterm capital gains tax benefits when their underlying shares are sold.

Nonqualified Stock Options (NSOs)

In contrast to ISOs, the Nonqualified Stock Options (NSOs) offer flexibility in recipients, extending beyond employees to include directors, consultants, and vendors. Taxation occurs upon exercise, with the spread between grant and exercise price treated as ordinary income. The company receives a corresponding tax deduction, making NSOs a good tool for incentivizing a diverse range of stakeholders.

Discounted NSOs

Should the grant price of an NSO fall below the fair market value of the underlying stock, it triggers additional considerations under Section 409A of the IRS Code. Noncompliance may lead to immediate taxation, penalties, and interest. Strict adherence to IRC Sec. 409A is essential to avoid pitfalls associated with discounted NSOs.

Restricted Stock and Restricted Stock Units (RSUs): Cultivating Commitment

Restricted Stock plans tie employees to a company by granting shares subject to specific restrictions. Vesting, often time-based, aligns with employee commitment. Filing a Sec. 83(b) election (under the IRS code) allows employees to pay tax early, at the time of grant, offering potential capital gains benefits. Similarly, Restricted Stock Units (RSUs) represent a promise for future shares, providing companies with flexibility in rewarding employee contributions without actual share transfers.

Vesting Strategies

Companies can strategically use both time-based and performance-based vesting to align employee interests with corporate goals. Time-based vesting ensures loyalty and commitment over an extended period; while performance vesting links rewards to specific achievements, fostering a culture of excellence.

Dividend Considerations

Understanding the tax treatment of dividends on restricted shares is crucial. Pre-vesting dividends are treated as additional wage income and reported on Form W-2. Post-vesting, dividends are treated as regular dividends and reported on Form 1099-DIV.

Stock Appreciation Rights (SARs) and Phantom Stock

SARs grant the right to receive payment based on stock value appreciation, often offering cash or stock options, allowing the employee to ride the growth wave of the company. Phantom Stock is a form of deferred compensation that mirrors stock value without actual share transfer, enabling companies to reward
employees without dilution. Each has unique tax implications, and careful planning is crucial for successful implementation.

Tax Implications

Understanding the tax implications of SARs and Phantom Stock is essential. SARs are subject to IRC Sec. 409A rules, ensuring fair market value at the grant date. Phantom Stock, treated as deferred compensation, provides flexibility in determining the value at the time of grant.

Employee Stock Purchase Plans (ESPPs): A Win-Win Strategy

ESPPs offer a win-win strategy by transforming employees into stakeholders. Qualified ESPPs provide tax advantages, allowing employees to purchase company shares at a discounted rate. However, adherence to specific requirements is essential to qualify for these tax benefits. The implementation of ESPPs fosters a sense of shared ownership, boosting morale and infusing capital through employee share purchases.

ESPP Withdrawal and Participation Flexibility

ESPPs often allow participants to withdraw from the plan before the offering period ends, providing flexibility. Additionally, participants can adjust payroll deduction rates during the offering period, accommodating changing financial circumstances.

Tax Reporting and Holding Periods

Understanding the tax reporting requirements and holding periods for ESPPs is crucial. Qualifying dispositions trigger favorable tax treatment, with only the gain treated as ordinary income. Disqualifying dispositions, while subject to ordinary income tax, may allow the company a deduction for compensation reported to the employee.

Conclusion

In a globalized business landscape, understanding the tax implications of equity grants is crucial when implementing incentive plans. The choices made in structuring these plans can impact not only the financial well-being of employees but also the overall success of the company. As we embrace the new year, innovative approaches to employee incentives, such as “Resolution Rewards,” can drive motivation and foster a culture of continuous improvement. The future of your business begins with the empowerment of your greatest asset—your people.


Business Insights is hosted by the Law Firm of KPPB Law (www.kppblaw.com) based in Atlanta, Georgia with additional offices in New York, Northern Virginia, Chicago, and Connecticut. Parav Patel is an associate with KPPB LAW’s Corporate Law Practice led by Co-Founding Partner Sonjui Kumar.

 


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