Founders and Execs Beware Part 1: The Options for Options Costly Tax Trap

Young companies often offer stock options to a prospective executive team in order to attract and retain them, as well as motivate them to drive the business to success.

The Story

Unlike outside investors, whose role it is to provide cash capital to the business, the executive team provides their human capital. Unfortunately for many of these executive teams, the cash contributors are more often in a position to value their contribution to the company considerably higher than the team’s contributions. Over time, this contribution disparity can result in dilution of equity granted to the executive team.

The Trap

Stock options are great tools in the finance world because an option owner can participate in the potential appreciation in a stock without having to outlay the cash for the investment. Unfortunately for  executives, stock options granted to employees (other than Incentive Stock Options) also create ordinary income when they are exercised. Conversely, if the individual had owned the stock from the beginning, rather than an option, a sale of that stock would be taxed at the lower capital gains rate.

The Opportunity

In a young company, where the early stock price is relatively low, executives should consider negotiating for outright stock grants rather than options. With this model, the company grants restricted shares to the employee at the outset. The restrictions are often identical to the vesting schedule that would otherwise be customary for stock options. However, an important difference between restricted shares and stock options is that, if structured correctly, the executive is taxed at the more favorable capital gains rate when the shares are sold.

Some Details

Restricted stock grants can be tax-free on the date of the grant. However, in young companies where the value is very low, the recipient can elect to treat the grant as taxable as of the grant date. The election (a so-called 83-B election) must be filed with IRS no later than 30 days after the grant and it must declare the value of the stock as of the grant date. Since the value of the stock is often low and this value is considered the taxable income, the corresponding tax is often nominal.

It should be noted however that in the current market environment, there are some new companies that begin with substantial initial valuations. This can result in a Restricted Stock grant that has substantial up front value and therefore greater tax cost.  In, Views from the Inside: Equity is a wonderful incentive, some solutions to this issue are examined.

Many founders and investors assume that stock options are the superior alternative when attempting to attract and retain an executive team. However, there are a variety of equity compensation plans, such as restricted stock, that may offer more efficient results for a particular company and its employees. A good plan can also allow companies to pick different alternatives for different employees or classes of employees to fit those individuals' tax and economic needs. Regardless of the type of compensation plan ultimately chosen, it is important to explore these options early.