Unlocking the Power of Equity-Based Incentive Compensation: An Overview of Equity-Based Compensation Alternatives
Equity-based compensation plays a pivotal role in attracting and retaining top talent and aligning employee incentives with an employer’s long-term success. By offering stock options, restricted stock units, or other forms of equity-based compensation, employers can foster a sense of ownership and commitment to the company’s future.
The challenge for employers is offering the right type of equity-based compensation for their employee population, industry, and long-term company goals. This article addresses the various types of equity-based compensation awards and assists employers with a common question: What type of equity compensation award is best for our company and our employees?
Over the course of the next six months, the attorneys at Foley & Lardner will help answer this common question in a series of articles on equity-based compensation. In this month’s article, we are offering an overview of the various equity-based compensation awards as a guide to the types of awards, tax treatment, and the advantages and disadvantages of certain awards.
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Nonqualified Stock Options (NSOs) |
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Description |
Tax Treatment |
Advantages |
Disadvantages |
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An option – NSO or ISO – is a right to buy
shares of company stock at a fixed price (the “exercise price”) over a
specified period. Must relate to “service recipient stock” and
have an exercise price that is no less than the stock’s fair market value on
the date of grant to be exempt from Code Section 409A. A company may grant NSOs to employees or
other individual service providers (e.g., consultants or board members). |
The optionholder is not subject to taxation
when the stock option is granted or when it vests. At exercise, (1) the optionholder will be
subject to ordinary income tax (and withholding) on the “spread” (FMV of the
shares on the date of exercise, minus the exercise price), and (2) the
company is allowed a corresponding tax deduction. At sale, any additional gains will be subject
to short- or long-term capital gains treatment. |
Possibility of large gains due to unlimited
potential increase in stock price is motivating to employees and aligns
interests with shareholders. Individual can elect when to recognize
taxable income; corresponding corporate compensation deduction opportunity. May be granted to non-employees. Generally understood by employees, so
motivational. |
No gain unless stock value increases. Spread is taxed as ordinary income and
subject to withholding. Optionholder must pay exercise price, which
may require borrowing money or selling shares to finance option exercise and
related tax obligation. Oftentimes does not result in long-term
capital gains because employees do not exercise until termination or company
sale. The company must determine the FMV of its
stock based on Code Section 409A rules or obtain a third-party appraisal (for
a fee). |
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Incentive Stock Options (ISOs) |
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Description |
Tax Treatment |
Advantages |
Disadvantages |
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Same as an NSO, except: ·
$100,000
annual vesting limitation. ·
Term
may not be more than 10 years. ·
Holding
period (i.e., stock cannot be sold
until two years after option grant and one year after exercise). ·
Limit
on post-termination exercise (e.g.,
one year after disability terminations, three months after other terminations
except for death). ·
ISOs
issued to 10% stockholders must have exercise price of 110% of fair market
value and a term of no more than 5 years. ·
A
company may not grant ISOs to non-employee service providers. |
The optionholder is not subject to taxation
when the stock option is granted or when it vests. At exercise, spread is not subject to
withholding and no corporate compensation deduction is allowed. But, the spread value is considered in calculating optionholder’s potential AMT obligation. Subsequent sale may result in a disqualifying
disposition, which may have adverse tax consequences to optionholder. |
Possibility of large gains (like NSOs). If holding periods are satisfied, individuals
may avoid ordinary income tax on the “spread”, i.e., the difference between
exercise price and sale price will be eligible for long-term capital gains
tax treatment). Generally understood by employees, so
motivational. |
More complicated to administer and understand
than NSOs because of additional regulatory requirements/restrictions and IRS
reporting obligations. The company is rarely eligible to claim a
compensation deduction (unless a disqualifying disposition occurs). Oftentimes does not result in long-term
capital gains/advantages being realized because employees do not exercise
until termination or company sale. May not be granted to non-employee service
providers. The company must determine the FMV of its
stock based on Code Section 409A rules or obtain a third-party appraisal (for
a fee). |
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Restricted Stock |
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Description |
Tax Treatment |
Advantages |
Disadvantages |
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An award of stock,
typically with no or nominal cost to the recipient, that is both non‑transferable
and subject to a substantial risk of forfeiture. Applicable
restrictions typically lapse over a period of three to five years. Dividends can be
deferred until restrictions lapse. May be granted to
employees or non-employees. Restricted stock is
generally not subject to Code Section 409A rules. |
Normally, the recipient is taxed when the
restrictions lapse – i.e.,
earlier of when the stock becomes transferable or is no longer subject to
forfeiture. However, the recipient may elect to pay taxes on the value of the
shares when awarded, so any post‑grant appreciation can be taxed as a
capital gain when stock is sold (an “83(b) election”). The company may take a deduction when the
recipient recognizes ordinary income (if any). Different tax rules apply to related
dividends. |
Provides opportunity to delay taxation, plus
flexibility for taxation at grant, if desired. Shares immediately owned by recipient (but
subject to forfeiture), so sense of ownership may be stronger than with other
devices, especially if there are voting and/or dividend rights. Potential for forfeiture (if recipient leaves
before restrictions lapse) can significantly aid retention. Requires no personal investment. |
Gain in market value not required for award
to provide incentive/value. Shares can be forfeited if early taxation is
elected; taxes will be lost as well if shares are forfeited. Unless early taxation is elected, the value
of the shares when the restrictions lapse is taxed as ordinary income, rather
than as a capital gain. Cannot time tax event (other than the
decision to make an 83(b) election). May create adverse shareholder reactions due
to appearance of getting “something for nothing.” |
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Profits Interests |
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Description |
Tax Treatment |
Advantages |
Disadvantages |
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Actual equity in an entity taxable as a
partnership that has no built-in gain on grant but shares in future profits
and changes in value. Common alternative when the entity granting
the right is taxed as a partnership. Generally should not be issued to non-US
employees without close coordination with foreign counsel. |
No tax consequences at grant. Allocation of income or loss annually under distribution
threshold in governing documents, if value has not
decreased. At redemption, normally will be long-term
capital gain. |
Generally, capital gain treatment on
redemption and, if so, no ordinary income tax. Significant flexibility in how the rights are
defined and when and how grantee shares in future value. Requires no personal investment. |
As of grant date the grantee is taxed as a
partner instead of an employee on all compensation, including need to make
quarterly estimated tax payments and exclusion from company’s cafeteria plan
(ability to pay for health insurance on a pre-tax basis). Possible to
structure around this. Can only be issued by partnerships. Generally, no company compensation deduction
available. Cannot issue options to purchase units or
partnership interests that are exempt from Code Section 409A if profits
interests are outstanding. |
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Restricted Stock Units or Phantom Equity |
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Description |
Tax Treatment |
Advantages |
Disadvantages |
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Notional units analogous to company shares,
with a value generally equal to the full value of a share of stock. Phantom stock is valued and paid at a fixed
date. This is often used by private companies that do not want the burdens of
issuing actual shares of stock to individuals. Will not be deferred compensation subject to Code
Section 409A if paid/settled at vesting. Payment/settlement may be in cash and/or
stock. May be granted to employees or non-employees. |
No tax consequences at grant. Value of the units is taxed as ordinary
income and is subject to income tax withholding (if employee) when
paid/settled. Corporate tax deduction is allowed for the
amount of the recipient’s taxable income. For grants to employees, FICA taxes generally
must be paid as phantom stock vests, not when paid. |
Cash-settled awards are often viewed as
easier to explain and administer. Service provider does not have shareholder
rights. Generally requires no personal investment. |
Gain in market value not required for award
to provide incentive/value. No opportunity for capital gains. Less flexibility in design if subject to Code
Section 409A. ERISA concerns if payout occurs only at
termination of employment or after long period (more than 10 years). |
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Stock Appreciation Rights (SARs) |
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Description |
Tax Treatment |
Advantages |
Disadvantages |
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Similar to NSOs, but usually settled in cash
based on the appreciated value of the underlying stock since the date of
grant. Award recipient is not required to pay an
exercise price. |
Similar to NSOs, but no opportunity for
capital gains. The company is entitled to a tax deduction
corresponding to the amount of ordinary income recognized by the employee. |
Similar to NSOs, but the award recipient does
not pay an exercise price. |
Similar to NSOs, but award recipient does not
have capital gains (unless award is made in stock). |
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