What you need to know before including stock options in your employee incentive program.
- A Range of Options. Stock options are just one form of employee incentive, all of which are intended to encourage key employees to make the company successful. In evaluating the alternatives, there are two important questions: What will incentivize the employees? How much ownership should the employees have?
- Don’t Believe the Tax-Free Hype. Incentive stock options (ISOs) are popular because they are believed to be tax-free for the employees. They’re not, in most cases. When ISOs are exercised, the “spread” (the difference between the exercise price and the fair market value of the stock) may not be subject to ordinary income tax, but it is subject to the alternative minimum tax (AMT). Also, when the stock is sold, the employee must pay capital gain taxes on the difference between the exercise price and the sale price.
- Through the ISO Hoops. To avoid ordinary income tax on the grant and exercise of ISOs, specific requirements must be met. At the time ISOs are granted, the exercise price cannot be less than the stock fair market value. ISOs must be exercised within ten years of being granted. After exercise, the option stock cannot be sold until two years after the date the option was granted and one year after the date the option was exercised.
- The Trigger Trap. Often the event that triggers the exercise of ISOs is a sale of the company. But exercise-and-sale as part of a company sale means that the employee cannot satisfy the two-year-from-grant and one-year-from-exercise holding requirements. As a result, the employee must pay ordinary income taxes on the difference between the option exercise price and the stock sale price.
- Plain Vanilla Options. Options that are not intended as ISOs are called non-statutory options (NSOs). Generally, the employee pays ordinary income taxes on the value of the options at the time they are granted, and the employer gets an immediate deduction for the same amount. There is no required time limit on when NSOs can be exercised, and there are no holding requirements.
- Restrictions May Apply. An alternative to options is restricted stock. Key employees are given company stock directly, but there are restrictions on voting rights, sharing in profits, or whatever the employer decides. However, the tax laws applicable to S corporations only permit restrictions on voting. Like NSOs, the employee generally pays ordinary income taxes on the value of the restricted stock at the time it is granted, and the employer gets a deduction.
- Tax Timing. Ordinary income taxes on NSOs and restricted stock can be delayed if they are subject to substantial risk of forfeiture. For example, restricted stock may be forfeited if the employee’s employment is terminated. The restricted stock would not be taxed until it becomes vested. However, the employee might choose to pay the tax early, by making an 83(b) election, if the stock is expected to go up in value.
- Real, Live Stockholders. Employees who exercise options or receive restricted stock are real stockholders. They are entitled to view the company books, to vote on directors and significant transactions, and they are owed fiduciary duties. The employer can impose some restrictions, but some stockholder rights by law cannot be limited.
- A Ghostly Alternative. Another alternative is “phantom stock.” Phantom stock is not actually stock at all. Instead, it is a promise to pay bonuses based on increases in the value of the company stock. Phantom stock avoids the complexity of ISOs and the stockholder rights of options and restricted stock. On the other hand, phantom stock may not incentivize employees as much as would stock ownership. If the name phantom stock isn’t scary enough, they’re also called stock appreciation rights (SARs).