Many startups and look for ways to attract, motivate, incentivize and retain employees by offering stock options, restricted stock or phantom stock. This is especially true when a company is unable to pay high salaries. When deciding what incentive plan is best for the company and the employee, it’s important to understand basics, especially in terms of both eligibility and tax consequences. Stock options, restricted stock and phantom stock plans all carry unique risks and rewards for the company. Here, we go through the basics of each.
One way to allow an employee to share in a company’s success is to grant the employee the ability (or option) to buy a stated number of shares at a defined grant price. The option vests over a period of time or when certain individual, group or company goals are met. Once vested, the employee may exercise the option at the grant price at any time over the option term up to an expiration date. There are two different types of options, which include incentive stock options or non-qualified stock options (also sometimes called non-statutory stock options). The largest difference between the two are eligibility and tax benefits. In both situations, the holder of the option pays a pre-determined amount of money to purchase common stock in the company, except when repayment is less than fair market value at the time the option is exercised. The primary disadvantage of stock option plans for the company is the possibility of dilution of other shareholder’s equity when the options are exercised.
Incentive Stock Options Versus Non-Qualified Stock Options
Incentive Stock Options (“ISO”) – Key Points
- Limited to the company’s W-2 employees. This means independent contractors and others, which are heavily utilized in startups and small businesses cannot be included.
- Employees must hold the stock for at least one year after the exercise date and for two years after the grant date.
- Only $100,000 of stock options can be exercisable in any calendar year
- The exercise price may not be less that the market price of the company’s stock on the date of grant.
- The option must be granted pursuant to a written plan approved by shareholders and must specify how many shares can be issued under the plan, and identify classes of employees eligible to receive the options. Options must then be granted within 10 years old the date of the board’s adoption of the plan.
- The option must be granted within 10 years of the date of the grant.
- If at the time of the grant, the employee owners more than 10% of voting power in all outstanding stock, the ISO exercise price must be at least 110% of the market value of the stock on that date, and may not have a term of more than 5 years.
- The employee may defer taxation on the option from the date of exercise until the date of sale of the underlying shares.
- The employee pays taxes on his or her entire gain at capital gain rates, rather than ordinary income tax rates
Non-Qualified Stock Options (“NSO”) – Key Points
- NSOs Can be offered to W-2 employees and other individuals such as consultants and independent contractors
- There are no special tax benefits for the employee – there is no tax on the grant of the option, but when exercised, the spread between the grant and exercise price is taxable as ordinary income. The company receives a tax deduction.
Restricted stock is another way to incentivize employees. Unlike an option, restrictive stock is issued at once, but subject to forfeiture if the employee stops working for the company before a designated time period lapses. Companies may choose to pay dividends, providing voting rights, or give employees other benefits of being a shareholder prior to vesting. When employees are awarded restricted stock, they may make a Section 83(b) election, where they are taxed at ordinary income rates on the “bargain element” of the award at the time of grant. If they do not make the election, the employee must pay ordinary income taxes on the difference between the amount paid for the shares and their fair market value when the restrictions lapse. The employer benefits from a tax deduction only for amounts which employees must pay income taxes, regardless of whether the employee has made an 83(b) election.
Phantom stock is a type of bonus plan that does not actually grant stock (thus, “phantom”), but rather provides the employee the right to receive an award based on the value of the company’s stock. Phantom stock provides a cash or stock bonus based on the value of the stated number of shares, to be paid out at the end of a specified period of time. Employers may offer dividend equivalent payments, and may condition the receipt of the award on meeting certain objectives, such as sales, profits or other targets. Phantom stock can be given to anyone, but if given broadly and designated to pay out on termination, it can be construed as a retirement plan, subject to federal retirement plan rules.
Any incentive plan should be considered carefully with the help of legal and tax experts. This article only covers basics and is not intended to be a comprehensive or complete overview. If you have questions or would like to set up an appointment to consider different incentive plans for your company (or are an employee who would like us to review an incentive plan provided by your employer), please call Sparkman + Foote attorney Christina Saunders at 303-396-0270 or contact by email at email@example.com