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 your 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.
| 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). |
| Incentive Stock Options (ISOs) | |||
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Description |
Tax Treatment |
Advantages |
Disadvantages |
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Same as an NSO, except:
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). |
| Restricted Stock | |||
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Description |
Tax Treatment |
Advantages |
Disadvantages |
|
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." |
| 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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Stock Appreciation Rights (SARs) |
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Description |
Tax Treatment |
Advantages |
Disadvantages |
|
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). |
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.