A General Tax Overview of Corporate Equity Arrangements

This paper is intended to be a general overview of the various types of equity arrangements that can be offered by corporations, meaning primarily C corporations. With that in mind, most of the arrangements discussed may also be utilized by S corporations, limited liability corporations that are taxed either as a partnership or a corporation, and partnerships. However, each of those types of entities potentially have disadvantages in attempting to offer the equity arrangements discussed in this paper and have in some cases better, more tax efficient alternatives to corporate types of arrangements. A discussion of those alternative arrangements is outside the scope of this paper.

Introduction

While there are possible variations on each type of arrangement, there are, in general, six types of equity compensation plans that can be offered to employees:

1. stock options,
2. restricted stock,
3. restricted stock units,
4. stock appreciation rights,
5. phantom stock, and
6. employee stock purchase plans.

Stock options grant employees the right to buy a fixed number of shares, at a price fixed as of the date the option is granted, for some number of years into the future. Restricted stock is shares of company stock granted to an employee and which are subject to restrictions that are, generally, either service-based or performance-based. The employee may or may not have to pay something to the company for the restricted shares. Restricted stock units (“RSUs”) are not real equity, but rather a promise by the company to pay a future amount at a specified time, either in cash or company shares, to the employee based on a fixed number of shares at the time the RSUs are granted. Phantom stock is also not real equity, but rather a corporate promise to pay a future cash bonus equal to the value of a certain number of shares. Stock appreciation rights (“SARs”) provide the employee with a contractual right to the increase in the value of a designated number of shares, to be paid in cash or shares. Employee stock purchase plans (“ESPPs”) are a broad-based arrangement giving employees the right to purchase company shares, usually at a discount.

Stock Option Arrangements

There are several key terms that are important in understanding how stock options work:

Exercise: The purchase of stock pursuant to an option agreement.

Exercise price: The price at which the stock can be purchased under the terms of the option agreement. This is also called the “strike price” or “grant price.” The exercise price is almost always the fair market value of the stock on the date the option is granted.

Spread: The spread is the difference between the exercise price and the fair market value of the stock at the time of exercise.

Option term: The length of time the employee can hold the option before the ability to exercise it expires.

Vesting: The requirement that must be met in order to have the right to exercise the option, which is usually a continuation of service for a specific period of time or the meeting of specific performance goals.

Types of Stock Options

Options are either 1) incentive stock options (“ISOs”), which are also referred to as statutory stock options, or 2) nonqualified stock options (“NSOs”), which are sometimes referred to as nonstatutory stock options.

Incentive Stock Options

An ISO enables an employee to 1) defer taxation on the option from the date of exercise until the date of sale of the underlying shares (however, see alternative minimum tax discussion below) and 2) pay taxes on the entire gain from the grant date to the sale of the shares at capital gains tax rates.

The following requirements must be met in order for an option to qualify for ISO treatment:

• The employee cannot sell the stock within one year after the exercise date or within two years after the grant date.
• Only $100,000 of stock options can first become exercisable in any calendar year. This is measured by the option’s fair market value on the date of grant. This means that only $100,000 in grant price value can become eligible to be exercised in any calendar year. Any portion of an ISO grant that exceeds the $100,000 limit in a calendar year is simply treated as an NSO for tax purposes.
• The exercise price must not be less than the fair market value of the company's stock on the date the option is granted.
• Only employees may be granted ISOs.
• ISOs can only be granted by entities that are taxed as corporations.
• The option must be granted pursuant to a written plan that has been approved by shareholders, specifies how many ISO shares can be issued under the plan and identifies the class of employees eligible to receive the options. Options must be granted within ten years of the date the board of directors adopts the plan.
• The option must be exercised within ten years of the date of grant, i.e., have a term of no more than ten years.
• If, at the time of grant, the employee owns more than 10% of the voting power of all outstanding stock of the company, the ISO grant price must be at least 110% of the fair market value of the stock on the date of grant and may not have a term of more than five years.

If all the rules for ISOs are met, then when the shares are sold the disposition will be considered a "qualifying disposition," and the employee will pay long-term capital gains tax on the total increase in value between the grant price and the sale price. The company does not get a tax deduction when there is a qualifying disposition, and there is no Form W-2 reporting. The exercise must be reported to the Internal Revenue Service and the employee on Form 3921.

If, however, there is a "disqualifying disposition,” usually because the employee exercises and sells the shares before meeting the required holding periods, the spread at exercise is taxable to the employee at ordinary income tax rates. Any increase or decrease in the shares' value between exercise and sale is taxed at capital gains rates. In this instance, the company may deduct the amount of the spread on exercise provided it reports the amount on Form W-2 in the year of the disqualifying disposition. Note that only the gross amount needs to be reported on Form W-2 and no income or payroll tax withholding is required.

Alternative Minimum Tax

Any time an employee exercises ISOs and does not sell the underlying shares by the end of the year of exercise, the spread on the option at exercise is a preference item for purposes of the alternative minimum tax (“AMT”). Thus, although the shares may not have been sold, the exercise requires the employee to add back the gain on exercise, along with other AMT preference items, to see whether an alternative minimum tax payment is due with their annual income tax return.

Nonqualified Stock Options

In contrast with ISOs, NSOs can be issued to anyone: employees, directors, consultants, vendors, etc. There are no special tax benefits for NSOs and, like an ISO, there is no tax on the grant of the option. However, when an NSO is exercised, the spread between the grant and exercise price is taxable as ordinary income and if the optionee is an employee (or former employee), it is treated as wages reportable on Form W-2. The company receives a corresponding tax deduction for the tax year the income is reported to the employee. There is no legally required holding period for the shares after exercise, although the company could impose one. Any subsequent gain or loss on the shares after exercise is taxed as a capital gain or loss (short-term if held 12 months or less; long-term if held more than 12 months) when the optionee sells the shares.

Discounted NSOs

If the grant price of an NSO is less than the fair market value of the underlying stock at the grant date, it is treated as deferred compensation under IRC Sec. 409A and must comply with the requirement that the time and form of payment be fixed at the date of grant. If the requirements of IRC Sec. 409A noted above are violated, the nonqualified stock options (or SARs) are immediately taxable or, if later, upon vesting (when the stock option is no longer subject to a substantial risk of forfeiture). The amount recognized as ordinary income by the grantee is the excess of the fair market value of the stock on December 31 less the exercise price and any amount paid for the option at grant. In addition, IRC Sec. 409A imposes a 20% penalty income tax on the gross income recognized and interest (if applicable) at the IRS underpayment rate, plus 1%. Further, any appreciation in the value of the option in subsequent years is also taxed under IRC Sec. 409A, up to and including the year the option is ultimately exercised. For employee stock options, employers must report income resulting from IRC Sec. 409A failures on Form W-2 in Box 1 and in Box 12 with code Z.

Restricted Stock

Restricted stock plans typically provide employees with grants of shares of stock at no cost, subject to specific restrictions. In some cases, the employee is required to pay for the restricted shares at a discounted price or at full fair market value at the grant date. However, the employee is not treated as the owner of the shares for tax purposes until the earlier of 1) the date the restrictions lapse or 2) the date the employee makes an IRC Sec. 83(b) election. For restricted stock, the most common restrictions are time-based vesting, typically requiring the employee to work for the company for an additional three to five years. Time-based restrictions may lapse all at once or in annual increments. In addition to time-based vesting, performance vesting may also be used. A company can restrict the shares until certain corporate, departmental, or individual performance goals are achieved. The employee is taxed at the earlier of 1) the date the restrictions lapse, or 2) the date the employee makes an IRC Sec. 83(b) election. The fair market value of the shares are reported as W-2 income to the employee and the company receives a corresponding deduction.

As noted above, the employee is not treated as the owner of the shares for tax purposes until the shares are vested or, if earlier, when the employee makes an IRC Sec. 83(b) election, i.e., once the employee has paid income taxes on the value of the shares. If the company pays dividends on the restricted shares prior to the lapse of the restrictions, the dividends are treated as additional wage income and are reported on Form W-2 for the calendar year in which they are paid. Once the restrictions lapse or the employee has made an IRC Sec. 83(b) election, any dividends paid are treated as dividends for tax purposes and reported on a Form 1099-DIV to the employee.

With restricted stock awards, provided state law allows it, the company can choose whether to pay dividends, provide voting rights, or give the employee other benefits of being a shareholder prior to the vesting of the restricted shares.

IRC Sec. 83(b) Election

When employees are awarded restricted stock, they have the right to make an IRC Sec. 83(b) election within 30 days of the receipt of the restricted shares. If they make the election, they are taxed at ordinary income tax rates on the fair market value of the shares at the date of grant less any amount paid for the shares. If the employee pays the full fair market value price for the restricted shares, there is no tax due as a result of making the IRC Sec. 83(b) election. However, the IRC Sec. 83(b) election should be made in order to avoid paying ordinary income tax on the increase in the value of the shares from the date of grant to the vesting date of the shares (see Alves v. Commissioner 734 F.2d 478 (9^th Cir. 1984), 84-2 USTC P 9546). Any future change in the value of the shares between the filing of the IRC Sec. 83(b) election and the sale of the shares is then taxed as a capital gain or loss, not ordinary income. If an employee does not make an IRC Sec. 83(b) election, taxes at ordinary income rates must be paid on the difference between any amount paid for the shares and their fair market value at the time of vesting. Subsequent changes in value to the date the shares are sold result in capital gain or loss.

For the employee, an IRC Sec. 83(b) election carries some risk. If the employee makes the IRC Sec. 83(b) election and pays tax, but later forfeits the shares, the taxes paid cannot be refunded. In this situation, the employee does have a capital loss subject to the regular deduction rules on an individual income tax return.

Restricted Stock Units

RSUs are not real equity, but rather a promise by the company to issue shares or pay cash to the employee at some date in the future and are treated as deferred compensation under IRC Sec. 409A. With RSUs, employees do not actually receive shares until the RSUs vest. In effect, RSUs are like phantom stock settled in shares instead of cash. Recipients of RSUs are not allowed to make an IRC Sec. 83(b) election, and, in contrast with restricted stock awards, the company cannot pay dividends, provide voting rights, or give the employee other benefits of being a shareholder prior to settling the RSUs in shares of company stock. Companies may pay dividend equivalents on RSUs; however, the amounts will be treated as additional wage income at the time of payment.

Stock Appreciation Rights and Phantom Stock

SARs and phantom stock are very similar in concept. Both are, in essence, bonus plans that grant not stock, but rather the right to receive a future payment based on the value of the company's stock. There are, however, important differences between the two. These include:

• SARs are subject to the same rules under IRC Sec. 409A that apply to stock option grants, including that the exercise price at the date of grant of the SAR is at least the fair market value of the underlying stock. Phantom stock is subject to IRC Sec. 409A as deferred compensation, and therefore the value of the phantom shares at the time of grant of the phantom stock can be any amount agreed to between the company and the employee.
• SARs typically provide the employee with a cash or stock payment based on the increase in the value of a stated number of shares from the date of grant to the date the employee exercises the SAR, which is done in a manner similar to the exercise of a stock option with the exception that the employee does not pay an exercise price. Phantom stock provides a bonus paid in cash or stock based on the value of a stated number of shares, to be paid out at the end of a specified period of time (frequently upon a liquidity event).
• SARs typically do not have a specific settlement date and, like options, the employee typically has flexibility regarding when to choose to exercise the SAR. Phantom stock may offer dividend equivalent payments; SARs cannot, as to do so would violate IRC Sec. 409A. When the payout is made, the value of the award is taxed as wage income to the employee (ordinary income to independent contractors, vendors, etc.) and is deductible by the company.
• Both SARs and phantom plans can condition the vesting of the award on meeting certain performance objectives, such as sales, profits, or other targets. Phantom stock plans must be limited to a select group of management or highly compensated employees in order to meet the requirements for nonqualified deferred compensation under the rules applicable to such plans. SARs can be given out more broadly to employees provided the grants are exempt from section 409A and are, therefore, not treated as deferred compensation.

Because SARs and phantom stock both essentially provide for cash bonuses, companies need to do some cash flow planning so that the company has sufficient cash to pay the required payroll tax withholding and so that the employee has the necessary cash to pay income taxes and their share of the payroll tax withholding. If the SARs and phantom stock are settled in cash, this does not present a problem. However, if awards are settled in shares, the employees will have phantom income and will need a source of cash to pay the taxes on the shares they received.

Employee Stock Purchase Plans

ESPPs are formal plans to allow employees to set aside money over a period of time known as the “offering period” to purchase the company’s stock. The funds to purchase the stock are taken out of their salary as after-tax payroll deductions and used to purchase the stock at the end of the offering period. ESPPs can be qualified under IRC section 423 or non-qualified.

Qualified ESPPs must meet the following requirements:

• The employee cannot sell the stock acquired under the plan within one year after the purchase date or within two years after the first day of the offering period.
• Only employees of the employer sponsoring the ESPP and employees connected by an unbroken chain of parent or subsidiary companies may participate.
• The plan must be approved by company shareholders within 12 months before or after adoption of the plan by the company.
• All employees with two years of service must be eligible for the plan, with certain exclusions allowed for part-time and seasonal employees, as well as highly compensated employees as defined under IRC Sec. 414(q).
• Employees owning more than 5% of the capital stock of the company cannot participate in the plan.
• No employee can accrue the right to purchase shares at a rate greater than $25,000 worth of shares, based on the stock's fair market value at the beginning of the offering period, for each calendar year in which the right to purchase is outstanding.
• The plan can provide for a maximum 15% purchase price discount on the shares based on either the fair market value price at the beginning or end of the offering period.
• An ESPP must provide, by its terms, that purchase rights granted under the ESPP cannot be exercised after the expiration of 27 months from the grant date unless, under the terms of the purchase right, the price cannot be less than 85% of the FMV of a share of stock at the time of purchase. If the purchase price formula is determined solely with reference to the 85% of purchase-date fair market value limitation, the purchase rights granted under the ESPP can be made exercisable for up to five years from the first day of the offering period.

Plans not meeting the above requirements are nonqualified and do not receive any special tax advantages.

In a typical ESPP, employees enroll in the plan and designate the amount to be deducted from their paychecks. During the offering period, the participating employees have funds regularly deducted from their pay and held in an account in preparation for the stock purchase. At the end of the offering period, each participant’s accumulated funds are used to buy shares, usually at a discount (up to 15% as noted above) from the fair market value.

Frequently, an ESPP allows participants to withdraw from the plan before the offering period ends and have their accumulated contribution returned to them without interest. It is also common to allow participants who remain in the plan to change the rate of their payroll deductions as time goes on. Under an ESPP, employees are not taxed until they sell the stock, and the company does not receive a tax deduction with respect to the shares transferred to the employee. The company must report the transfer of the shares acquired by an employee pursuant to the exercise of a purchase right on Form 3922. As with ISOs, there is a one-year/two-year holding period to qualify for the special tax treatment as noted above. If the employee meets the holding period requirements, then there is a "qualifying disposition." As a result, the amount of ordinary income recognized by the employee equals the lesser of 1) the actual gain (the amount by which the market value of the shares on the date of sale exceeds the purchase price), or 2) the purchase price discount (however, if the purchase price is based on the lower of the value of the stock on the first or last day of the offering period, the purchase price discount is computed as of the first day of the offering period). Any additional gain or loss is a long-term capital gain or loss.

If the holding period requirement is not satisfied, there is a disqualifying disposition, and the employee pays ordinary income tax on the difference between the purchase price and the stock value as of the purchase date. Any additional gain or loss is a capital gain or loss. For both qualifying and disqualifying dispositions, the company reports the ordinary income recognized by the employee on Form W-2 as “other compensation” and is not required to withhold either income or payroll taxes. For a qualifying disposition, the company is not entitled to a tax deduction for the income reported to the employee. If there is a disqualifying disposition, the company will be entitled to a deduction equal to the amount includible as compensation in the employee’s gross income for the taxable year in which a disqualifying disposition occurs.

Conclusion

The preceding information is a general overview of each of the various types of corporate equity arrangements. Within each type of arrangement there are manifold complexities in applying the general rules and additional rules that are outside of the scope of this paper. Accordingly, it is important that companies considering implementing any type of equity arrangement seek the advice of a qualified professional.