Offering employees stock options can provide a way for companies to attract top executives and incentivize employees. Stock options are particularly popular with startups that may not have financial resources to be able to pay high salaries or offer large bonuses in the early years. They can also be used as a way to increase retention and motivate employees with a share in the company.
Before companies begin offering stock option plans to employees, they need to understand the accounting, tax, and securities implications of offering stock options. Companies also have to consider the logistics of offering options, including getting shareholder approval, plan administration, the right of first refusal, pricing and timing, securities compliance, and IRS 409A valuation.
Benefits and Disadvantages of Stock Option Plans
One key advantage of offering stock option plans is the ability to offer a more attractive benefits package at a lower salary. This allows a company to seek and retain top employee talent. However, a primary disadvantage of stock option plans for employers is the potential to dilute overall shareholder equity in the company.
There are a number of options companies can choose from in deciding how to structure their stock option plans. Some plans offer greater tax advantages for the company while others offer special tax status for the employees.
Qualified or Statutory Stock Options
Stock option plans for employees can be generally divided into qualified and nonqualified (or statutory and nonstatutory) stock option plans. One primary benefit of qualified stock option plans is that employees generally do not have to include any amount in their gross income when they receive or exercise these options.
Incentive Stock Option (ISO)
Incentive Stock Options (ISO) are one example of a qualified stock option plan. With ISO plans, there is no tax due at the time the option is granted and no tax due at the time the option is exercised. Instead, the tax on the option is deferred until the time you sell the stock. When the stocks are sold, the employee is taxed on the difference between option price and fair market value as well as any appreciation. If the stock is sold more than two years after the option was granted, and more than a year after it was exercised, the gain is taxed at the long-term capital gains rate.
The main drawback for ISO plans is that employers do not get the same tax advantages as they do for nonqualified plans. For this reason, ISOs are generally a benefit reserved for company executives and limited employees. ISOs have other limitations for companies and executives. No more than $100,000 in incentive stock options can be exercisable in a year. Options that exceed the $100,000 limitation fail to qualify as incentive stock options. ISOs may also expose individuals to the alternative minimum tax (AMT).
Nonqualified Stock Options (NSO)
Nonqualified or nonstatutory stock options may offer a company more flexibility because they are not restricted to statutory obligations. Nonqualified options may be more easily transferred and can also be offered at discounted rates. However, employees in nonqualified plans do not receive the same special tax treatment as compared to statutory option plans.
In most cases, an employee will not owe tax on nonqualified stock options at the time they are granted. However, when the employee purchases or exercises the option, they may have to pay the income tax on the difference between the option price and the fair market value of the option.
The amount of income to include and when to include the income in your taxes may depend on the fair market value of the options. Income must still be included as the fair market value received on the exercise, less any amount paid, at the time you exercise the option. At the time the option is sold, any gain is generally treated as a capital gain or loss.
A primary benefit of nonqualified stock option plans is for employers. Companies may be able to deduct the difference in option price and fair market value as a compensation expense in their corporate taxes. Employers do not get the same tax advantage with qualified stock option plans.
Employee Stock Purchase Plan (ESPP)
An employee stock purchase plan (ESPP) is a program where employees can purchase company stock at a discounted price. ESPPs can be set up either as a qualified plan or a nonqualified plan. Nonqualified plans may provide companies with greater flexibility in how they offer their plans but they may lose some of the tax advantages.
ESPPs may use payroll deductions to build up funds to buy stock at the lower market price during the offering period. After the employee buys the stock, they may have the option of selling the stock, or holding onto the stock as a long-term investment. In many cases, the employee is able to realize a profit because the stock was purchased at a discount.
The discount rate depends on the company program but may be as high as a 15% discount. Many ESPPs allow the participants to purchase the stock at the lower of the price between the offer date and the purchase date.
Qualified ESPPs are usually set up as tax-qualified Section 423 plans. To qualify, ESPPs generally have to be available to all full-time employees with a certain amount of time vested in the job. Participants may need to hold their shares for at least one year after the purchase date and two years after the grant date to take advantage of the long-term capital gains rate.
It is important to understand that employee stock purchase plans (ESPPs) are not the same as employee stock option plans (ESOPs). ESOPs are a type of retirement plan.
San Diego Stock Option Plan Attorneys
Butterfield Schechter LLP is San Diego County's largest firm focusing its law practice primarily on employee benefit legal services. We provide our clients with cutting edge employment benefit plan design. Our attorneys will help establish a stock option plan that meets the needs of your company while providing the maximum benefit to plan participants. We can also assist clients and plan administrators with regular reviews and updates to maintain regulatory compliance. Contact our office today with any questions on how we can help you and your company succeed.