Equity-Based Compensation Awards
Prior to 1970, executives received wage income similar to other employees of a company. However, a change in paradigm indicated that aligning top executives’ interests with those of the company and its shareholders could be a more efficient way to retain top talent and increase the profitability of the company. Thus began the era of equity-based compensation.
Executives today can be offered various types of stock-based compensation that are either qualified or nonqualified. The difference impacts the timing of the realization of the compensation and therefore the associated tax liability. Four characteristics are important in determining realization and cash receipt:
- Grant Date
- Vesting Date
- Date of Exercise
- Date of Sale
Qualified plans are statutory and have special tax treatment. Qualified plans include:
- Incentive Stock Options (“ISOs”) and
- Employee Stock Purchase Plans (“ESPPs”)
To qualify for the beneficial tax treatment of either of these two plans, the recipient must not sell the stock within two years of grant or within one year of exercise of the option. The benefit of adhering to this holding period is to receive capital instead of ordinary treatment on the income.
Incentive Stock Options
ISOs can be exercised in the future at the fair market value (“FMV”) as of the date of grant. The difference between the FMV on the date of exercise and the exercise price (“the spread”) is not included in regular income on the date of the exercise. However, it is treated as a tax preference item that increases income for alternative minimum tax (“AMT”) purposes even though no money is actually received. Typically, this will trigger the AMT tax. Of course, an executive could exercise and sell sufficient amounts of the stock to cover the AMT tax, but the income would then be ordinary instead of capital. Awards are limited to $100,000 per year.
Employee Stock Purchase Plans
In general, ESPPs allow an employer to grant its employees the right to purchase stock at the then-current FMV and sell it at some time in the future, with any increase being treated as a capital gain. However, since this form of compensation is only allowed up to $25,000 per year, it would not be a large component of the executive’s compensation package.
Nonqualified plans are those that do not receive beneficial tax treatment. These plans include Nonqualified Stock Options, Restricted Stock, Restricted Stock Units and Stock Appreciation Rights.
Nonqualified Stock Options (“NSOs”)
NSOs give the executive the right to purchase the company’s stock at a fixed price within a fixed period of time subject to a vesting schedule. There is no limit on the dollar value of the NSOs that can be granted to an executive. In general, there is no income realization on the date of grant. Ordinary income is realized for “the spread” on the date of exercise.
Restricted Stock (“RS”)
RS is non-transferable and must be traded in compliance with SEC Rule 144. Vesting periods generally range from three to five years.
The Metropolitan Corporate Counsel
July/August 2014 Issue
Read the entire article here.