Equity incentives, which include stock options, help cash-starved start-up companies compensate employees, consultants and other service providers without breaking the bank. Even if you don’t plan to hire employees early-on, adopting an equity incentive plan is beneficial because you can also grant equity as compensation for the work of consultants and other service providers. Start-up technology companies typically reserve 10-20% of the total equity of the company for incentive grants pursuant to an equity incentive plan, but businesses that expect to make significant hires early on may want to reserve a bit more (the amount reserved under the plan can also be increased at any time, but generally requires shareholder approval).
There are several forms of equity incentives, and it is important to understand the tax and accounting implications of each in addition to the impact each can have on the equity ownership of your company. This post gives a high level overview of the most popular forms of equity incentives among technology companies – stock options and restricted stock – but while we note some basic tax considerations below, this entry does not purport to explain the tax or accounting implications of granting options or restricted stock. It is very important that you consult with your professional advisors before putting in place an equity incentive plan for your company or making equity incentive grants. Also, this entry only concerns private companies and does not attempt to deal with various issues that publicly traded companies must address in connection with making equity incentive grants.
Equity Incentive Plans and Grant Agreements
Equity incentive grants are usually made subject to various conditions that are spelled out in an equity incentive plan (often just called an “option plan”) or in the grant itself. The plan usually gives the company’s Board of Directors, or a committee of the Board, the power to make grants and determine the conditions of each grant, including when the recipient’s rights in the grant are no longer subject to forfeiture (called “vesting”) should the recipient’s service with the company end. The grant may provide for vesting upon occurrence of certain events, but most technology companies issue options and restricted stock that vest over time. A common vesting schedule would provide for a percentage of the options or restricted stock to vest after one year, with the remainder vesting monthly or quarterly over the following two to three years.
Options
A stock option gives the recipient (or “optionee”) the right to acquire a set number of shares of the company’s stock (referred to as shares “underlying” the option or “option shares”) subject to certain conditions. The optionee pays nothing up-front for the option, but the option does not confer on the optionee any benefits of stock ownership – such as voting rights or the right to receive dividends – until the underlying shares are purchased (also known as “exercising” the option) by payment of a predetermined exercise (or “strike”) price for each share. There are two types of options distinguished by their treatment under the Internal Revenue Code (IRC) – nonqualified stock options (NQOs) and incentive stock options (ISOs).
Nonqualified stock options may be granted to employees, directors, consultants and other service providers, but when the option is exercised the difference between the strike price and the then-current fair market value of the underlying shares (called the “spread”) is taxed to the optionee as ordinary income, subject to withholding, and the company receives a corresponding compensation deduction. Any further gain realized when the stock is sold is taxed at the applicable short or long-term capital gains rate, depending on the length of the holding period following exercise. Incentive stock options may only be issued to employees, but unlike NQOs the optionee does not recognize any taxable income when the option is exercised (though the spread is taken into account in calculating the employee’s alternative minimum tax, if applicable) and instead only reports income when she sells the underlying shares, at which time the entire taxable income (the difference between the sale price and the strike price) is treated as long-term capital gain instead of ordinary income. In order to realize the tax benefits of an ISO, the optionee must not sell the underlying shares for at least two years after the option is granted and at least one year after the option is exercised. If the holding period requirements or other conditions in the IRC are not met, then the option converts to a NQO and the optionee is taxed accordingly.
Restricted Stock
Unlike options, which give the recipient the right to acquire shares of a company, restricted stock is actual stock that comes with all of the benefits of stock ownership. Restricted stock is subject to conditions imposed by the company at the time of grant, including the company’s right to repurchase the stock should the recipient’s service with the company end before the restricted stock vests. Restricted stock is usually issued in exchange for cash and/or services at a price per share equal to or less than the stock’s fair market value, and the recipient is required to pay any cash portion of the purchase price at the time the grant is made. The default tax treatment for restricted stock requires the recipient to recognize ordinary income as the restricted stock vests (over time or upon the occurrence of specified events) on the difference between the original purchase price for the shares and their fair market value at the time of vesting. If the stock is subsequently sold, the recipient must recognize a taxable capital gain or loss on the difference between the sale price and the fair market value of the stock at the time of vesting. The recipient may, however, make an election under Section 83(b) of the IRC to pay tax on the value of the entire grant in the year the award is made in exchange for the right to claim capital gain treatment on any future gain. An 83(b) election, which must be made within 30 days of the award, requires the recipient to treat as ordinary income the difference between the original purchase price of the restricted stock and the fair market value of the stock on the date of grant. If the stock is subsequently sold, the recipient would have a taxable capital gain or loss on the difference between the sale price and the original purchase price.
Tags: contractors, employees, restricted stock, stock, Stock options, Vesting
Tags: contractors, employees, restricted stock, stock, Stock options, Vesting