the dilemma of how to provide equity
compensation to employees on a tax
efficient basis which is attractive to both
the employer and the employee. These
issues and decisions differ depending
on the structure of the business, whether
corporate or partnership. Below are
considerations and the impact of each
when providing equity compensation to
employees.
wants the employee to pay for the stock.
employer stock is the appropriate choice.
Options allow employees to benefit from
the increase in value of the stock because
employees can wait until the underlying
stock appreciates to exercise the option.
An option can be tailored by the employer
to be exercisable immediately, or in
installments based upon future events,
such as continued employment or
attainment of performance criteria.
If granting options is the correct
decision for the employer, next consider
whether the employer wants a federal
income tax deduction for the "spread"
between the option exercise price and the
fair market value of the shares subject
to the option at the time the option is
exercised. If the employer expects a
deduction, the employee will recognize
income in the amount of the employer's
deduction.
If the employer expects a federal
income tax deduction, the option granted
will be a non-qualified stock option
(NQSO). With NQSO, the employee
recognizes income at the time the option is
exercised in the amount of the spread, and
the employer is entitled to a corresponding
deduction. NQSOs should be granted
at an exercise price equal to the fair
market value of the stock on the date of
grant in order to avoid potential deferred
compensation issues. The fair market
value of the stock on the date of grant can
be determined using minority interest
and lack of marketability discounts, if
appropriate.
If the employer desires to forego the
deduction associated with a NQSO, the
employer can grant an incentive stock
option (ISO). When the employee exercises
income in the amount of the difference
between the exercise price and the fair
market value on the date of exercise.
ISOs are subject to statutory requirements
under the Internal Revenue Code, and
have certain rules and restrictions. An
ISO must be granted pursuant to a written
plan approved by the stockholders of the
employer within 12 months after the plan
is adopted, must be granted within 10
years of the date the plan is adopted and
cannot be exercisable after the expiration
of 10 years from the date of grant. The
exercise price must not be less than the
fair market value at the time the ISO is
granted, and ISOs may not be granted
to any individual who owns more than
10 percent of the stock of the employer.
If the employer is willing to provide
equity without requiring any payment from
the employee, the equity is essentially a
substitute for a cash bonus. Stock can then
be awarded to the employee. The award
can vest immediately or over time and may
be subject to restrictions on exercisability.
If the stock vests immediately, the
employee will be taxed on the fair market
value of the stock at the time it vests,
and the employer will obtain a federal
income tax deduction in the same amount.
Fair market value can be determined by
taking into account minority interest and
lack of marketability discounts. If the
stock vests over time, based, for instance,
on continued employment as of specific
future dates or on the achievement of
performance criteria by the employee,
the employee will be taxed on the fair
market value of the stock at the time it
vests and the employer will be entitled
to deductions in equivalent amounts at
such times.
practice group for Thomas & Libowitz, P.A. He
has a broad background in stock bonus and
stock option plans; executive compensation;
complex subchapter C, K and S issues and
tax planning; method of accounting issues;
tax exempt organization issues and tax issues
relating to real estate acquisition, ownership,
disposition and development.
100 Light Street
Suite 1100
Baltimore, Maryland 21202
410.752.2046 Phone
rsnyder@tandllaw.com