Equity-based compensation strategies

By Michael Maryn

The attached outline summarizes several of the most common forms of equity-based compensation awards for employees and directors of, and consultants to, non-public U.S. companies, and describes generally the tax, accounting, and securities law effects of each on the company and the recipients of the awards.

Mechanically, to establish a program of equity-based compensation, the board of directors of the company would adopt a plan. The plan could permit one or more of the types of awards described in this outline. The identity of the grantees, the timing of the awards, and the size of the awards would all be at the discretion of the board, with no requirement for uniformity. Each grantee would receive an agreement, setting out the terms and conditions of his or her award. The granting or exercise of an award should, if actual equity is involved, be contingent on the grantee’s becoming a party to a shareholder agreement limiting resale rights, and possibly imposing other requirements (such as an obligation to vote the same as the majority shareholders, particularly on major matters such as a merger).

This memo is based on the assumption that the employer company is a C Corporation, but the tax, securities and accounting principles would apply to S Corporations as well. However, S Corporations establishing equity compensation arrangements need to be mindful of the 100 shareholder limit, and the requirement that the corporation have only one class of stock. Generally, a typical employee option to acquire common shares of an S Corporation has not been considered to be a separate class of stock. Phantom arrangements may be unattractive for S Corporations, not only because of the risk that the phantom arrangement could be deemed a separate class of stock, but also because of the potential difficulty of building a reserve to meet the eventual cash obligation. The funds would be taxed to shareholders in the year they are earned and set aside by the corporation, but the corporation would not be able to take a deduction until the year of payment.

Non-Qualified Options

A non-qualified option (so-called to distinguish it from an “incentive stock option” described below) is the opportunity to purchase stock of the company in the future, at a price (exercise price) determined at the date of grant.  The exercise price must be not less than the fair market value of the stock on the date of grant.  The right to exercise the option will typically vest over 3-5 years, but vesting terms is determined solely at the discretion of the board.  The term of an option is typically 10 years.  A vested option could be exercised anytime during the 10-year term while the grantee is employed, and for a limited period of time (e.g. 90 days) after termination of service.

Tax effect on grantee

  • No tax on grant or at time of vesting. On exercise, the excess of the fair market value of the shares over the exercise price (called the “spread”) is taxable as ordinary compensation income and is subject to FICA (for employee-grantees) or SECA (for director- or consultant-grantees).
  • Future changes in value are long- or short-term capital gain or loss, recognized when the stock is sold or otherwise disposed of. Realized gain may be subject to Medicare tax on investment income.
  • To avoid potential excise taxes, the exercise price must be no less than fair market value of a share of stock on the date of grant.

Tax effect on company

  • Deduction upon exercise in the same amount as the service provider includes in income.
  • For grants to employees, the spread will be subject to the employer portion of FICA upon exercise.

Securities considerations

  • Private company benefit plan exemption (Rule 701) generally available to avoid SEC registration. If more than $5 million in value (based on value of underlying stock, NOT value of the option) granted in any 12-month period, significant financial disclosures are required.
  • May be subject to filing requirements under state blue sky laws.

Accounting considerations

  • Generally, the “fair value” of the option (based on an option pricing model such as Black-Scholes) is taken as an accounting charge over the vesting period of the option.

Pros

  • For grantees, an option represents the opportunity for real share ownership, including voting and dividend rights.
  • Appreciation in stock price after exercise of the option is taxed at the short- or long-term capital gain rates (depending on how long the stock is held before it is sold).

Cons

  • Stock ownership in a private company is a generally illiquid form of investment.
  • After exercise of an option, the grantee will become a shareholder, which will give the grantee certain rights to company financial information.
  • Transfer (sale) rights, rights of first refusal, put and call rights, and the valuation mechanism all must be elaborated in a shareholder agreement. The company will probably be expected to buy back stock from departing service providers.
  • Unless the company advances funds to the grantee, the grantee will need to come up with cash needed to pay the exercise price and applicable taxes due.
  • The potential for dispute exists (with the IRS, and/or between the grantee and the company) as to the “fair market value” of the stock.

Incentive Stock Options

A form of option which is subject to certain volume limits and holding period requirements. The employee receives special tax treatment. The company generally has no deduction available.

To qualify as an incentive stock option, among other things,

  • the option must be granted pursuant to a written plan, approved by shareholders, which states the maximum number of shares that may be granted under the plan and identify the employees who are eligible to receive grants;
  • incentive stock options may not be granted to non-employee directors or consultants.
  • incentive stock options only $100,000 worth of stock (valued at date of grant) may become exercisable for any grantee in any year;
  • the option cannot be exercisable more than three months after termination of employment, except in the case of death or disability; and
  • the option price must be at least the fair market value of the stock on the date of grant (110% of fair market value in the case of a grant to a 10% shareholder)
  • the term of the option may not exceed 10 years (5 years in the case of a grant to a 10% shareholder)

Tax effect on employee

  • No tax at grant or upon exercise. However, employee may be subject to alternative minimum tax (AMT) on the spread on exercise.
  • If shares received on exercise are held one year after exercise and two years after grant (“Holding Period”) the gain, i.e., the excess of the fair market value of the stock upon disposition by the employee over the exercise price, is taxed as a long term capital gain.
  • If the Holding Period is not met, the spread (or actual gain, if less) is taxable to the employee as ordinary compensation income (i.e., tax treatment is similar to a non-qualified option).
  • Not subject to FICA upon exercise or upon disposition of the shares whether or not the Holding Period is met. But, gain may be subject to Medicare Tax on investment income.

Tax effect on company

  • No deduction if the Holding Period is met. If the Holding Period is not met, the spread (or actual gain, if less) is deductible by the employer (i.e., tax treatment is similar to a non-qualified option).
  • Not subject to the employer’s portion of FICA.

Securities considerations

  • Same as for non-qualified options.

Accounting considerations

  • Same as for non-qualified options.

Pros (compared with non-qualified options)

  • Perceived as a benefit to employees because all tax (other than AMT) is capital gain.
  • Permanent avoidance of FICA on exercise of option.
  • Can be granted in conjunction with non-qualified

Cons (compared with non-qualified options)

  • Unless the company advances funds to the grantee, the grantee will need to come up with cash needed to pay the exercise price and AMT (if applicable) on exercise . Cashing in shares (e.g., by selling them back to the company) to pay the tax or exercise price violates the Holding Period requirements, which will result in additional taxation to the employee.
  • Disputes may arise with the IRS on the determination of “fair market value.”
  • The company has a permanent loss of tax deduction if the Holding Period is
  • Not available to non-employee directors and consultants.

Restricted Stock

Stock awarded or sold to service provider, subject to the condition that the service provider forfeit the stock (or sell it back at the lesser of fair market value or the service provider’s purchase price) if the vesting conditions are not satisfied. Vesting conditions may be time-based or performance based.

Tax effect on service provider

  • 83(b) Election. If the grantee files an “83(b) election” with the IRS within 30 days of grant (or purchase), the grantee will recognize ordinary compensation income at date of grant (or purchase) equal to fair market value of shares on that date (less purchase price, if any). That amount will also be subject to FICA. Future changes in value are long- or short-term capital gain or loss upon sale of the stock. No tax when shares vest. If shares are forfeited (or sold) because the vesting conditions are not satisfied, loss is limited to the amount actually paid for the shares.
  • No 83(b) Election. No tax at date of grant (or purchase). Ordinary compensation income equal to the fair market value of shares when and as they vest (less purchase price, if any). That amount will also be subject to FICA. Future changes in value are long- or short-term capital gain (or loss) upon sale of the stock.

Tax effect on company

  • Employer is entitled to a tax deduction upon vesting (or filing an 83(b) election) in the same amount that the grantee includes in ordinary compensation income. This amount will also be subject to the employer portion of FICA when the shares vest (or an 83(b) election is filed).

Securities considerations

  • Private company benefit plan exemption (Rule 701) generally available to avoid SEC registration. If more than $5 million in stock and options (based on value of underlying stock, NOT value of the option) granted in 12 month period, significant financial disclosures are required.
  • May be subject to filing requirements under state blue sky laws.

Accounting considerations

  • Unless the grantee pays fair market value for the stock (in which case there is no accounting charge), the spread between the grantee’s purchase price (if any) and the fair market value of the shares on date of grant is taken as an accounting charge over the vesting period. If the grantee does not pay for the stock, which is the most common case, then the full fair market value of the stock is taken as an accounting charge over the vesting period.

Pros

  • With an 83(b) election, all subsequent gain will be capital gain.
  • Actual stock ownership, with voting and dividend rights. Dividends may be subject to same forfeiture restrictions as the stock.

Cons

  • For a private company, stock ownership is a generally illiquid form of investment. (No cash to pay tax.)
  • Same disadvantages of minority shareholders as with
  • Transfer (sale) rights, rights of first refusal, put and call rights, and valuation mechanism all must be in a shareholder agreement. The company will probably be expected to buy back stock from departing grantees.
  • If grantees make 83(b) election, company tax deduction is limited to grant-date value of the stock (less purchase price, if applicable).

Stock Appreciation Rights

A stock appreciation right (“SAR”) is the right to receive in cash an amount equal to the appreciation in value of a share of stock between the grant date and the exercise date (called the “spread”). The right to exercise the SAR will typically vest over 3-5 years. The term of an SAR is typically 10 years. A vested SAR could be exercised any time during the ten-year term while the grantee is employed, and for a limited period of time (e.g. 90 days) after termination of service.

Tax effect on service provider

  • No tax upon grant or vesting. Full value of spread taxable as ordinary compensation income upon exercise. Spread is also subject to FICA upon exercise.
  • To avoid potential excise taxes, value of SAR must be limited to the increase in the fair market value of a share of stock between the date of grant and the date of exercise, and there can be no feature for deferral of compensation.

Tax effect on company

  • Deduction upon exercise in the same amount as the service provider includes in income.
  • Spread is subject to employer portion of FICA upon exercise of SAR

Securities considerations

  • No federal registration (or applicable registration exemption) should be necessary if SAR is settled in cash.
  • Need to check state blue sky laws.

Accounting considerations

  • “Spread” is taken as an accounting charge and “marked to market” quarterly.

Pros

  • SARs can avoid some of the corporate and securities law complications of options or restricted stock, because they are a cash vehicle.
  • There is no need for buy-back rights, shareholder agreements, etc., and the service provider need not come up with cash to exercise the right or to pay the taxes due on exercise.
  • There would be no requirement to share financial information about the company, as there would be with actual share ownership.

Cons

  • SARs may not have the same subjective value to service providers as stock, because they do not represent actual share ownership.
  • May require substantial cash outflow when SARs are
  • Once an SAR is exercised, the grantee no longer shares in future growth in value of the company, as he or she would with actual stock.
  • Public companies generally eschew SARs because of the adverse accounting treatment.
  • Some valuation issues – see discussion of phantom stock (below).

Phantom Stock

Phantom stock is the right to be paid, in cash, at a specified date, in an amount equal to the then-fair market value of a specified number of shares of company stock. Permissible payout triggers include only (1) separation from service with the company and all of its affiliates, (2) a specified date that is objectively ascertainable on the date of grant (e.g., upon attainment of age 65), (3) death, (4) disability, (5) unforeseeable financial emergency of the grantee (in which case only the amount needed to meet the emergency can be paid), or (6) change in control of the company. The phantom stock may or may not carry dividend equivalent rights, separately documented. It does not include voting rights. It may be subject to a vesting schedule. The phantom arrangement could also be limited to the increase in value of the stock from grant date to the trigger date, in which case it is more like an SAR.

The tax, accounting, and securities considerations for phantom stock are generally the same as for stock appreciation rights, both for the company and the service provider, except that FICA including the Medicare portion (applicable with respect to employees only) must be paid on the value of phantom stock when it vests, regardless of when it is taxable for income tax purposes.

ERISA Considerations: Most phantom stock arrangements applicable to employees come within the definition of “pension plan” under ERISA, if they “result in a deferral of income by employees extending to the termination of covered employment or beyond.” To avoid application of the full panoply of ERISA rules, care must be taken to assure the plan is a “top hat” plan (“a plan which is unfunded and is maintained by an employer primarily for the purpose of providing deferred compensation for a select group of management or highly compensated employees”). ERISA does not apply to non-employee service providers.

Pros

  • Permits key employees and grantees to share in growth in value of the company, without making a cash investment.
  • Avoids minority shareholders.
  • Since payment is in cash, avoids problems associated with lack of marketability of stock.
  • If separation from service triggers a freezing of value (whether or not the payout is postponed until retirement age), the grantee will not participate in increases in value occurring after separation from service.

Cons

  • Financially dilutive effect on shareholders is the same as if actual shares were given away.
  • May require substantial cash outflow at payment date.
  • Valuation problems can be exacerbated, e.g., need to account for dilution if additional employees are later granted phantom units; need to adjust for the fact that the accounting records of the company will reflect an accrual for the phantom units.
  • Full amount taxed to employee as ordinary compensation income, not capital gain.