Businesses today face many different kinds of challenges, but one that is especially difficult to resolve is securing and motivating talented employees. How do you motivate your employees to think of themselves as an important piece of the puzzle in growing the value of your company? One tried and true method of doing so is through equity compensation. Issuing equity to your employees can help flip their mindset from just an employee to now a partial owner of the business.
Two of the most common forms of equity compensation are stock options and restricted stock. Each comes with their own effects and requirements as it comes to cash, taxes, and general procedure. However, both typically come with vesting schedules, restrictions on transfer, and potential chances for forfeiture. Below is a further discussion on the differences between the two.
One potential choice for equity compensation is issuing stock options. This is one of the most common and well-understood forms of equity compensation. The company issues to an employee an option to purchase a set number of shares at a set price, typically the current fair market value at the time of issuance. This is an option to purchase, meaning the employee at some point will have to exercise the option and actually pay for the stock (though options for cashless exercise exist). The price is locked in at the date of grant, so the bet is that the company’s value increases, but the employee still gets to buy in at the lower value. This allows the employee to share in the upside growth of the business from that day forward, but it also preserves the existing value of the company for those who grew it to that point.
Stock options come in two different forms: incentive stock options (ISOs) and non-qualified stock options (NQOs). While the practical effect of these options are the same, ISOs come with special tax treatment from the IRS that is generally more favorable to the employee. However, with that special tax treatment comes more restrictions. These restrictions are fairly detailed, but they generally revolve around the required timing of exercise by the employee and the proper waiting period before an ultimate sale of the stock.
Because stock options are just an option to purchase in the future, the employee is not taxed at the time he or she receives the options. However, upon exercise of the option, the employee will be taxed on the difference between the fair market value of the company at the time of exercise minus the exercise price (the “spread”). The company can then also deduct the spread from its taxes as compensation paid. If the option is an ISO, then there is actually no tax effect upon exercise by the employee.
The other common choice for equity compensation is restricted stock. The key difference between stock option and restricted stock is that restricted stock is an actual grant of equity – the employee is not required to purchase but is instead just awarded the equity (while being subject to vesting). However, this brings potentially unwanted tax consequences to the employee. The IRS views this grant of restricted stock as “income” received by the employee. This means the employees must pay taxes on that income, even though no cash is actually changing hands.
The important question here becomes when that tax is owed. The default position is that tax is owed when the restricted stock vests, which could be years from the date of grant. The benefit here is that the employee only pays taxes when he or she actually earns the stock; the drawback here is that stock is now probably worth more than it was on the date of issuance (assuming growth by the business). This means the employee has to pay more in taxes. However, the IRS allows you to make an 83(b) election, which is an election made by the employee to pay the taxes on issuance rather than at vesting. This allows the employee to lock in a likely lower value, paying less taxes than if the business grows in value over time; the downside here is that the employee is paying taxes on equity that they might never get if they don’t meet vesting requirements. That tax money does not come back to the employee, so it is a bet that the employee sticks around to meet vesting.
While there are plenty of other ways to structure equity compensation, stock options and restricted stock are the most commonly used choices. These structures can provide your business with additional tools to recruit, motivate, and retain talented employees within your business. Reach out to William Daniel or your BrownWinick attorney with any questions you may have. BrownWinick is here to assist you in structuring these transactions in the most advantageous way for your business and your employees.