Incentive compensation can be in the form of cash or equity. There are pros and cons to each. We’ll start with cash because it is easier to understand and we’ve already seen some examples of cash based incentive compensation (ex. referral bonus).
We can also incentivize people by giving them a “phantom” stock option or stock appreciation rights. More on these after we discuss stock options.
Sometimes the best way to incentivize someone is to offer equity or ownership if a goal is reached. Ownership in the company can be alluring to employees for several reasons:
- Morale – working as an owner, with the owners, not for the owners.
- Motivation – work harder to create value for the company and oneself.
- Voting Rights
- Dividend or Distribution Rights
- Sale/Liquidation Rights – if the company gets sold or liquidates, one gets a piece of the sale.
- Tax Benefit – upon sale of the ownership interest, one will incur capital gains and therefore taxed at a lower tax rate.
A stock bonus can be done for the same reasons as stated above for cash bonuses. Cash bonuses are ordinary income to their recipients and tax deductible to the company. They can either be directly given without a contingency or they can be tied to a goal or timeframe (restricted stock bonus).
Restricted Stock Bonus Example: On January 1, 2020, when the stock is worth $100/share, our VP for Marketing is told that they will be given 25 shares of stock in the year that sales net of marketing expenses exceed $1M. VP is also told that they have to meet this goal within 5 years or the deal is off the table. This is an incentivizing stock bonus. On March 30, 2021 VP meets the goal, and the company gives them the 25 shares, which are now worth $250/share.
There are some tax questions here.
- Is VP taxed on January 1, 2020 when the promise is made or not until March 30, 2021 when the goal is met and they receive the shares?
- What is the taxable amount?
- Is the taxable amount capital gains or ordinary income?
In order to answer the first two questions, we need to consult IRC § 83.
Section 83(a) says that if you have property (here shares of stock) that have a substantial risk of forfeiture (), then the recipient waits until the substantial risk of forfeiture is gone to report the income. So, when does the VP include their shares in their income? March 30, 2021 because that is when the goal was satisfied – therefore the substantial risk of forfeiture was gone.
Next question is how much is VP’s tax liability? How does 83(a) help answer this question?
The fair market value of the property at the time the substantial risk of forfeiture was met minus the amount paid. Here the shares were worth $6,250 (25 shares x $250/share) on March 30, 2021 and VP paid nothing for them. As such, VP will include $6,250 in their gross income on their 2021 tax return. This will all be ordinary income and the company will take a deduction of $6,250 in 2021. Of note, VP’s basis is $250/share.
Let’s look at the optional election in §83(b). This section allows VP to elect to be taxed on the January 1, 2020 promise ignoring the substantial risk of forfeiture, in 2020 instead of 2021. Let’s do the math. VP feels confident that they will meet the goal and is equally confident that the company’s stock price will go up significantly as a result. VP can do an 83(b) election to pay the tax based on the promise in 2020 and do so at the fmv of the stock on the day of the promise. VP will include $2,500 (25 shares x $100/share) as income on their 2020 tax return. This will all be ordinary income and the company will take a deduction of $2,500 in 2020. VP now has a basis of $2,500 in the stock – even though they don’t own the stock yet. In 2021 when VP meets the goal and receives the stock it is worth $6,250 but VP does not need to do anything more from a tax perspective until they sell the stock. If VP sells the stock in 2021 for $6,250, then gain is calculated by the following computation: $6,250 – $2,500 = $3,750. This gain will be capital gain.
What is the catch you may ask? The catch is that if one elects to use 83(b) there is no going back. In other words, if VP was wrong and they did not meet the goal within the 5 years and they have no chance of actually getting the shares, they will have paid tax on something they do not have. This is the gamble. See, 83(b)(1)(B).
Let’s compare 83(a) vs. 83(b) assuming ordinary income rate of 30% and capital gains rate of 15%.
|Under 83(a)||Under 83(b) election|
$6,250 x .3 (30% rate) = $1,875 tax
$2,500 x .3 (30% rate) = $750 tax
|Sell in 2021 for $6,250
$6,250 – $6,250 (basis) = $0 cap gain
$0 cap gains tax
|Sell in 2021 for $6,250
$6,250 – $2,500 (basis) = $3,750 cap gain
$3,750 x .15 (15%) = $562.50 cap gains tax
|Total tax paid
|Total tax paid
Bonus stock is great for executives because it does not cost them anything, and depending on how the deal is worded, can be incentivizing. If the company is privately owned, the individual will need to be part of the buy/sell agreement – or a new one will need to be created for them – so they have the ability to sell the shares. Because they own actual shares in the company, the goals set forth above for ownership apply.
There is a notable drawback. Assuming VP does not sell the shares, they need to come up with the money to satisfy the tax liability. This is referred to as phantom taxable income. There are strategies that companies can use to help VP cover these taxes. One is by providing a loan. The loan has to be a bona fide loan with an interest rate at market, and a repayment schedule. When I’ve done this in the past, the executives had a payroll deduction to cover the loan repayments. However, the loan can be structured such that the repayment does not occur until the exec sells the shares. If one is not careful in drafting such loan arrangements, the loan could be considered as compensation yielding different tax results than what was intended. Same goes for loan forgiveness. See, Dana S. Fried, Always Consider the Tax Aspects of Employer-Employee Loans, April 17, 2017.
Another strategy to help VP pay their tax liability is to simply give them the money. Of course this disbursement of funds will be ordinary income. Lastly, the company can offer to buy the shares in a coordinated exercise-sale scenario. This way the money would be available to pay for the tax liability, but VP would have to give up the shares.
Stock options are the most common form of equity compensation that a startup uses. A stock option is simply an option granted to an employee to buy shares at a later date. For example, we can tell VP that they have the ability to buy 20 shares at the end of the year at a price of $100/share. When VP buys the stock or “exercises the option” the company gets the money because it is selling stock to VP. 💡 Do you see why stock options are popular for startups?
The above sample stock option gives VP the right to buy shares later at a certain “strike” price (usually the price the stock is valued at on the date of grant). Definitionally, a stock option gives a person the right to buy a designated number of shares at a designated price over a designated time frame. There are two types of stock options and both are taxed differently.
- Incentive Stock Options (IRC §§ 421-422) (ISOs)
- Non-qualified Stock Options (NSOs)
ISOs are options that are granted pursuant to an Incentive Stock Option Plan. This means that a Plan document has to be drafted with the details regarding how the options granted pursuant to the plan will work. The Plan will also have the total number of shares that can be granted pursuant to the plan – this is not just for one individual but rather for the entire group of people who may be getting options.
Example: X Corp has an Incentive Stock Option Plan under which 100,000 shares can be issued as options. X Corp’s Compensation Committee of the Board of Directors has approved the following incentive stock option grants:
|Officer||Date of Grant||No. of Shares||Strike Price||Exp. Date|
First note that now that 8,000 options have been granted (even though they have not yet been exercised) we need to reduce the number of options in our ledger from 100,000 available to 92,000. I had a client fail to do this and ran over once. This was problematic because the shareholders have to vote for an Incentive Stock Option Plan and all amendments thereto. As such, we had to hold a Special Meeting of Shareholders in order to increase the number of available shares. Fortunately, we received shareholder approval.
Mechanically how does this work? Let’s say that CEO is ready to exercise options representing 10 shares in 2021 when the stock price is now $14/share. To exercise, they pay the company $120 (10 x $12). The stock is actually worth $140. By being granted the option to buy previously and locking in the strike price at what was likely the fair market value of the stock on 1/1/2020, CEO was able to watch the stock and buy it through the option later when they knew it was worth more. If the option was an ISO then there are certain tax advantages.
There are certain tax advantages of using ISOs:
- No income to the executive at the time of option grant (so in our example, CEO 1/1/2020)
- No income to the executive at the time of exercise
- So long as executive does not dispose of the stock within 2 years of the grant date or within 1 year after exercise. (See, IRC § 422 (a)(1))
- Basis is price paid for the shares: $120. When CEO sells, they will have capital gain on the difference between what they sell for and the basis (what they purchased the shares for.)
This is a pretty sweet deal, right?! So what does the IRC require in order to get this advantageous treatment? (See, IRC § 422 (b))
- Plan must be adopted by the company’s shareholders within 12 months of board’s adoption.
- Option granted within 10 years of plan adoption.
- Option period may not exceed 10 years.
- Option strike price not less than FMV of stock at time of grant.
- Option cannot be transferable by executive, except on death.
- Executive cannot own more than 10% of the company.
- FMV of all stock first subject to ISOs for any one individual in same calendar year (determined as of grant date) can’t exceed $100,000. (See, IRC § 422(d)).
- Executive can’t sell within 2 years of grant or 1 year of exercise to get capital gains benefits.
- Executive must be employee from time of grant until 3 months before exercise.
Remember that these are options to buy stock. This means that it costs the executive money to purchase, but it also means the company gets that money and can use it for working capital however it would like. Because there are no tax consequences until the executive sells the stock, there is no phantom income issue. While this all sounds great (and it is for the exec), the company does not get any deduction associated with the ISO. 💡 Think about why that is? Also, compare ISOs to stock bonuses.
Another point to be made here from a tax perspective is that ISOs are an alternative minimum tax (AMT) preference item under IRC § 56(b)(3). What this means is that ISOs are one of the few items that can trigger AMT because ISOs provide a tax benefit that can potentially significantly reduce the regular tax of high-income taxpayers. The AMT sets a limit on the amount the ISO benefits can reduce one’s total tax. While a deep dive into the mechanics of AMT is not appropriate here, it is important to know that AMT can apply and is particularly important when dealing with ISOs for founders because we often want founders to be able to exercise enough shares to not have to pay the AMT but to also start the time clock on the “one year from exercise requirement” to get capital gains benefits. It is important that clients understand that a Form 3921 needs to be filed with the IRS when ISOs are exercised. Andrew Carroll, CPA and financial planner for freelancers and solopreneurs, tells me that he postulates that only 50% of companies actually remit the Form 3921. Neither Andrew, nor I, condone this lack of filing.
From a drafting standpoint, there is an Incentive Stock Option Plan and then any time there is a grant of options, there needs to be an ISO Agreement with the specific individual who has been granted the option (the optionee). The ISO Agreement sets for the items shown in the table above: Name, Date of Grant, Number of Shares, Strike Price, Exp. Date.
The ISO Agreement can also provide for a vesting schedule. If a company wants to handcuff an executive, it will insert a vesting schedule into the ISO Agreement. For example, perhaps the company wants to dribble the options over a certain amount of time, say 5 years. As such, CEO may be able to exercise only 1,000 options per year, instead of all 5,000 anytime within the 5 year period.
📖 For a stock option checklist, see Cisco Palao-Ricketts, Stock option grant checklist for startups, DLA Piper.
Non-qualified Stock Options are not tax advantaged and they do not meet the requirements of an ISO. As such, they have virtually no rules as to what you do. This is great for flexibility but not so great for tax purposes. Some companies have Non-qualified Stock Option Plans but they don’t need to. Companies can have arrangements that are different for each individual.
The tax implications:
- No income to executive at time of option grant if option not tradable and no readily ascertainable FMV of option.
- Ordinary income to executive at time of exercise – Excess of FMV of stock over option price paid.
- Long-term capital gain at time of sale for recognized appreciation post exercise if holding period satisfied.
- Company gets a tax deduction at exercise equal to executive’s tax hit.
- A 409A issue if underpriced (beyond the scope of this book)
Let’s use the same example as earlier but let’s say this is a NSO arrangement.
|Officer||Date of Grant||No. of Shares||Strike Price||Exp. Date|
Like before, let’s say that CEO is ready to exercise options representing 10 shares in 2021 when the stock price is now $14/share. To exercise, they pay the company $120 (10 x $12). The stock is actually worth $140. What happens? Upon exercise, CEO is taxed. CEO has ordinary income in the amount of the excess of the FMV of the stock over the price paid – $140 – $120 = $20. Why? Because CEO is getting a good deal. CEO is able to buy shares at a discount because of the option. As such, that discount is taxed as ordinary income. CEO’s basis is $140. This represents the amount paid for the option and then the amount that tax was paid on already (the other $20). Ultimately when CEO sells, they will have capital gain.
Note unlike with ISOs, with NSOs there is phantom income at the time of exercise.
A company can combine ISOs and NSOs into one Stock Option Plan if it wishes to do so. 📖 Read this sample plan.
Stock Appreciation Rights/Stock Equivalency
Both stock bonuses and stock options provide real ownership in the company. But sometimes employees do not want ownership; they’d rather have cash. And sometimes a company wants to incentivize without giving up ownership. 💡 Think about why this is?
We can incentivize without giving up ownership in the company by essentially pretending to give stock so that the employee can receive the appreciation in the value of the stock. This is simply a contractual promise to compensate based on the increase in the stock’s value. Stock appreciation rights are called SARs.
Let’s modify our VP example (blacklined so you can see the edits): On January 1, 2020, when the stock is worth $100/share, our VP for Marketing is told that they will be given stock appreciation rights equivalent to 25 shares of stock in the year that sales net of marketing expenses exceed $1M. VP is also told that they have to meet this goal within 5 years or the deal is off the table. This is an incentivizing
stock bonus but gives no real stock. On March 30, 2021 VP meets the goal, and the company gives them cash in the amount of what the 25 shares are worth now less what it was worth previously, which are now worth $250/share – $100/share ($3,750).
The above is accomplished via contract. Sometimes the trigger is more like a handcuff, a set duration instead of an accomplishment or goal. For instance, the trigger could be that on January 2, 2024, VP will receive the equivalent of what 25 shares of stock is worth. The contract must set forth how the valuation will be determined.
- The $3,750 that VP receives is compensation and is taxable ordinary income in the year received.
- The company gets a corresponding deduction.
💡 If you were VP, which would you prefer, stock bonus, stock option, or SAR? Think beyond the real ownership aspect and consider tax consequences of each.
Consider one of the benefits of real ownership: dividends. If VP had actual ownership/stock, then they would be eligible for dividends. What about in the SAR situation? If you put it in the contract, sure. There is no SAR plan required by the IRS or anyone else so the company can be flexible in its contracts among its executives. Caution: Be mindful of 409A when drafting.
Partnerships and LLC Members – Sub K Part II
Having learned about stock appreciation and such, how can we incentivize executives in our unincorporated entities?
- Ownership Appreciation Rights can be given that mimic SARs.
- Ownership interests can be given as bonuses like stock bonuses with the same tax considerations under §83 as mentioned above.
- Profits only interests can be given for services. These give no managerial or liquidation rights.
(a) General rule
If, in connection with the performance of services, property is transferred to any person other than the person for whom such services are performed, the excess of—
(1) the fair market value of such property (determined without regard to any restriction other than a restriction which by its terms will never lapse) at the first time the rights of the person having the beneficial interest in such property are transferable or are not subject to a substantial risk of forfeiture, whichever occurs earlier, over
(2) the amount (if any) paid for such property,
shall be included in the gross income of the person who performed such services in the first taxable year in which the rights of the person having the beneficial interest in such property are transferable or are not subject to a substantial risk of forfeiture, whichever is applicable.
The preceding sentence shall not apply if such person sells or otherwise disposes of such property in an arm’s length transaction before his rights in such property become transferable or not subject to a substantial risk of forfeiture.
(c) Special Rules
For purposes of this section—
(1) Substantial risk of forfeiture
The rights of a person in property are subject to a substantial risk of forfeiture if such person’s rights to full enjoyment of such property are conditioned upon the future performance of substantial services by any individual.