High growth companies often find that offering employee stock compensation can be an effective motivator to attract and retain top talent.

Before offering employees an ownership stake in a business as a differentiator in talent management, it is important to consider the various models for issuing employee stock compensation and the distinctions that exist between them.

The three forms of employee stock compensation are nonqualified options, qualified options and restricted stock units (RSUs). All three of these models grant employees the opportunity to participate in a company’s common stock, but the requirements associated with each are different and can come with tax implications.

Nonqualified Employee Stock Options

Nonqualified options are company stock rights issued to employees, vendors and board directors. They are generally taxed when granted if the option has a readily ascertainable value at the time it was offered.

For a nonqualified stock option to hold a readily ascertainable value, the option must be transferrable, exercised immediately in-full when granted, and without conditions or restrictions set that would significantly affect value. Additionally, the fair value of the option privilege must be readily ascertainable.

If there is a readily ascertainable value, the employee recognizes ordinary income in that amount in the year the stock is granted. In cases where there is a cost to the employee, the ordinary income is the value of the option minus the cost.

However, it is unusual for the option to have a readily ascertainable value. More often, there is not one and the taxable event is the exercise date, not the grant date. On the date of exercise, the employee recognizes ordinary compensation income based on the fair market value (FMV) of the stock purchased less amounts paid (if any) for the option. The basis of the stock is the actual exercise price plus any ordinary income recognized. Any future sale of the stock could result in capital gains or loss.

Qualified Employee Stock Options

Qualified stock options are those that are issued to employees only. Two common qualified stock options are incentive stock options (ISOs) and options under an employee stock purchase Plans (ESPP).

An ISO allows an employee to purchase stock in their employing company at the current fair market value in anticipation of the stock appreciating at a later date, that when sold generates beneficial long term capital gain rates, rather than ordinary compensation income.

In order for a stock option to qualify as an ISO, the following requirements must be met:

  • The ISO must be granted under a plan and approved by shareholders.
  • The options must be granted within 10 years of when the plan was adopted or approved. They must also be exercisable within 10 years of the grant date.
  • The exercise price may not be less than the FMV of the stock at the date of the grant.
  • The employee may not own more than 10 percent of the combined voting power of the corporation, parent, or subsidiary as of the date of the grant with some exceptions.
  • Once exercised, the stock must be held at least two years after the grant date and at least one year after the exercise date to be qualified.
  • The employee must remain an employee of the corporation from the date the option is granted until three months (one year if due to permanent and local disability) before the option is exercised.

Meanwhile, an ESPP allows employees to purchase their employers’ stock by using after-tax payroll deductions. Requirements for an ESPP stock option are:

• The plan must be written and approved by shareholders.
• An ESPP cannot grant options to any employee who has more than five percent combined voting power of the corporation, parent, or subsidiary.
• The plan must include all full-time employees (with the exception of highly compensated employees and those with less than two years employment).
• The option exercise price may not be less than the lessor of 85 percent of the FMV of the stock when granted or exercised.
• The option cannot be exercised more than 27 months after the grant date.
• No employee can acquire the right to purchase more than $25,000 of stock per year.
• Once exercised, the stock must be held at least two years after the grant date and at least one year after the exercise date.
• The employee must remain an employee of the corporation from the date the option is granted until three months before the option is exercised.

If the ESPP stock is sold after the holding period requirements listed above, the appreciation of the FMV at the time of grant is considered long term capital gain.

Restricted Stock Units

Finally, restricted stock units (RSUs) represent an unsecured promise by the employer to grant a set number of shares of stock to the employee upon the completion of a vesting schedule. Some types of plans allow for a cash payment to be made in lieu of the stock, but that type of plan is the minority. Ordinary compensation income is recognized on the date of vest.

Shareholders of restricted stock are allowed to report the fair market value (FMV) of their shares as ordinary income on the date that they are granted instead of when they become vested if they desire. This election can greatly reduce the amount of taxes that are paid because the stock price at the time of grant is often much lower than at the time of vesting. Therefore, capital gains treatment begins at the time of grant and not at vesting.

The RSU option can be especially useful when longer periods (i.e. five years or more) exist between when shares are granted and when they vest.

Before Offering Employee Stock Compensation

Given the many possible tax implications and other distinctions related to the structure of employee stock offered, businesses are advised to speak with a tax professional prior to implementing any new compensation models.

For specific questions on whether employee stock offerings are right for your business, contact Rob Sacks, Tax Partner, at rsacks@dbllp.com