Stock in Trade
To achieve maximum advantages for the company and recipients, an equity compensation plan must comply with a host of securities and tax laws
By Julia Caputo Stift
Julia Caputo Stift is an associate in the Los Angeles office of Morgan, Lewis & Bockius LLP. Her practice focuses on federal, state, and local taxation matters, including equity compensation.
In this time of rapid economic growth and ever riskier business ventures with their potential exponential rewards, companies are discovering that often the only way to retain the service providers—employees, directors, and consultants—that are necessary to the success of the companies' business ventures is to provide the service providers with an opportunity to share in the ultimate profitability of the companies.1 The efforts of companies to recruit and retain service providers has led to an explosion of equity compensation vehicles designed to meet the special concerns of all parties.
When a company goes through the process of choosing the forms of equity participation that it will offer, its fundamental goal is to retain and motivate valued employees and other service providers. At the same time, employers will be concerned about the dilution effect of the issued equity interest on the outstanding ownership of the company. The company also will want to make sure that the equity compensation vehicle in fact aligns the interests of service providers with those of the company. Furthermore, employers desire flexible equity incentive vehicles that permit the structuring of compensation packages specifically tailored for key employees.
After addressing these issues, many companies have chosen to implement stock incentive plans that permit a company's board of directors, or a compensation committee appointed by the board of directors, to grant several different forms of equity compensation to their service providers. The three most common forms of equity compensation are incentive stock options, nonqualified stock options, and restricted stock.
The formation and implementation of stock incentive plans is largely controlled by securities laws. Federal and California securities laws exempt the compensatory issuance of stock pursuant to a qualified stock incentive plan from registration requirements for transactions involving the sale of securities as long as certain criteria are met:
- The plan must be in writing and established by the issuer or its affiliates for the participation of their employees, directors, officers, consultants, or advisers.2
- The plan must provide the total number or percentage of shares of stock that may be issued pursuant to the plan.3
- The plan must state who is eligible to receive stock pursuant to the plan.4
- The plan must provide that in the event of a stock split, reverse stock split, stock dividend, recapitalization, or combination or reclassification of the issuing corporation's stock, the number of purchasable shares and the exercise price will be appropriately adjusted.5
- The plan must terminate no later than 10 years from the date the plan is adopted or approved by the shareholders, whichever is earlier.6
- The plan must be approved by the shareholders within 12 months before or after the date of the plan's adoption.7
- The plan must provide that optionees and restricted stock recipients will receive financial statements at least annually.8
The aggregate value of the securities granted pursuant to the stock incentive plan may not exceed the greater of 1) $1 million, 2) 15 percent of the total assets of the issuer, or 3) 15 percent of the outstanding amount of the class of securities being offered and sold in reliance on the compensatory transaction registration exemption.9 In order to determine the number of outstanding shares of stock of the issuer, all outstanding, currently exercisable, or convertible options or warrants will be treated as outstanding.10
In order to fall within the federal and California registration exemptions, stock issued pursuant to the plan must have a purchase price—or, if the stock is granted pursuant to an option, an exercise price—that is at least 85 percent of the fair market value of the stock at the time the stock or option is granted.11 If the recipient of an option "owns stock possessing more than  percent of the total combined voting power of all classes of stock of the issuing corporation or its parent or subsidiary corporations," the exercise price of the option must be at least 110 percent of the fair market value of the stock at the time the option is granted.12
Similarly, if the recipient of restricted stock "owns stock possessing more than  percent of the total combined voting power of all classes of stock of the issuing corporation or its parent or subsidiary corporations," the purchase price of the restricted stock must be at least 100 percent of the fair market value of the stock at the time of grant.13 Options issued under a qualified plan must not be exercisable after 10 years from the date of grant.14
Along with meeting exercise restrictions imposed by securities laws, options and stock granted pursuant to an incentive stock plan must comply with securities law requirements governing vesting, transferability, and treatment upon termination of employment. Incentive stock plans must limit the transferability of options and restricted stock issued pursuant to the plan to transfer by will or the laws of descent and distribution.15 The right to exercise options issued under a stock incentive plan must vest at a rate of at least 20 percent per year over five years from the date the option is granted, except for options granted to officers, directors, or consultants.16 If the service relationship of an optionee is terminated for reasons other than cause, the optionee must be entitled to exercise his or her options to the extent the optionee is otherwise entitled to exercise those options at the time of termination for a minimum time frame following the optionee's termination. If the termination was a result of the optionee's death or disability, the period during which the terminated individual may exercise his or her vested options must continue for at least six months from the date of termination. If the termination was not based on death or disability, the optionee must be entitled to exercise his or her vested options for at least 30 days from the date of termination.17
In addition to the general requirements and restrictions imposed on stock options and restricted stock by the securities laws, federal tax law imposes requirements. Whether or not those requirements are met determines the federal income tax treatment afforded to a recipient of equity compensation.
The Most Common Vehicles
Incentive stock options—also referred to as statutory stock options or ISOs—meet all of the requirements set forth in Internal Revenue Code Section 422. Employees generally prefer ISOs to nonqualified stock options because ISOs are tax advantageous to the recipient. This special tax treatment will not be realized, however, if an ISO does not comply with all of the many statutory requirements under the IRC for ISOs. Specifically, an ISO:
- Must be granted to an individual as part of an equity compensation plan, and the option must be offered in connection with the individual's employment by the issuer.18
- Must be granted under a plan that states the aggregate number of shares for which options may be issued, states the employees eligible to receive options under the plan, and is approved by the company's shareholders within 12 months before or after the plan's adoption.19
- Must be granted within 10 years from the date the plan was adopted or approved by the shareholders, whichever is earlier.
- Must not be exercisable after 10 years from its date of grant.
- Must not have an exercise price that is less than the fair market value of the underlying stock at the time the option was granted.
- Must be nontransferable other than by will or the laws of descent and distribution.
- Must be exercisable, during the optionee's lifetime, only by the optionee.20 However, at the time the option is granted, if the recipient of an option owns more than 10 percent of the total combined voting power of all classes of stock of the employer corporation or of a parent or subsidiary of the employer corporation, the option will not qualify as an ISO unless the exercise price is at least 110 percent of the fair market value of the stock at the time the option is granted and the option is not exercisable after five years from its date of grant.21
- May not present itself as other than an ISO. Any option that specifically states that it will not be treated as an ISO is not an ISO, regardless of its terms.22
- May not result in an individual receiving ISOs from any issuer that result in options for stock with an aggregate fair market value of more than $100,000 (as determined on the date the ISOs were granted) becoming exercisable for the first time in any given calendar year. If the maximum value of options first exercisable by an individual in a calendar year exceeds $100,000, the excess will not be treated as an ISO.23
For example, if an employee is granted options intended to qualify as ISOs for stock that has an aggregate fair market value of $500,000 at the time of grant and the options vest 20 percent per year over a five-year period, the entire amount of the options can constitute ISOs because the amount of stock for which options become exercisable in any given year is $100,000. Future increases in the fair market value of the stock will not affect the determination of whether or not the options qualify as ISOs, as the fair market value of the stock for purposes of the $100,000 limitation is determined at the time the options are granted.24 If, however, the employee receives an additional grant of stock options with a fair market value at the time of grant of $10,000, and these additional options vest in the third year of the initial ISO grant, the additional $10,000 of stock options cannot constitute ISOs because, in the year they vest, the amount of ISOs received cannot exceed $100,000. The excess will be treated as nonqualified stock options.
A nonqualified stock option is any stock option issued as equity compensation that fails to meet the requirements of an ISO. Most significantly, nonqualified stock options may be granted to all service providers rather than just to employees. Nonqualified stock options must meet the requirements of federal and California securities laws to obtain an exemption from the registration of transactions involving a sale of securities.25
An award of restricted stock is a means by which company management can seek a closer alignment of the interests of service providers with the interests of the company by immediately granting service providers a direct equity interest in the company. A company often wants to use the stock issued for the purpose of aligning service provider and company interests as a mechanism to retain the recipient employee or other service provider. When using stock as a retention tool, the stock a company issues to its service providers is either forfeited or may be bought by the company pursuant to a predetermined price or formula if an employee leaves the company, or a service provider terminates his or her relationship with the company, before the restrictions lapse on the granted stock.
At the time of issuance, none of these equity compensation vehicles have any federal income tax consequences for service providers or employers. However, the overall tax consequences of ISOs, nonqualified stock options, and restricted stock differ substantially. (See "Tax Treatment of Equity Compensation Vehicles," page 38.)
ISOs are designed to provide tax advantages to employees. At the time the options vest, the employee does not incur any federal income tax consequences. Similarly, at the time the employee chooses to exercise an ISO, no ordinary income or capital gain is recognized.26 The issuing corporation, however, does not receive any business expense deduction in connection with the exercise of the option. The difference between the fair market value of the stock at the time of disposition and the exercise price is taxed at the long-term capital gain rates that are in effect when the stock is disposed of, so long as:
- The disposition occurred more than one year after the acquisition of the stock and more than two years from the date of grant of the option.
- The optionee was an employee of the issuing corporation, or a parent or subsidiary of the issuing corporation, throughout the period beginning at the date of grant of the option and ending on a date three months before the date of the exercise of the option.27
In the event the optionee has not held the stock for at least two years from the date of the grant of the option and at least one year from the date of exercise of the option, the option fails to be an ISO—and the option is treated as a nonqualified stock option. The optionee is taxed at ordinary income tax rates upon the lesser of 1) the difference between the fair market value of the stock at the time of disposition and the exercise price, and 2) the difference between the fair market value of the stock at the time the option was exercised and the exercise price. If the fair market value of the stock at the time of disposition exceeds the fair market value of the stock at the time of exercise, the optionee is taxed on the difference at capital gain rates.
As with ISOs, there are no federal income tax consequences for service providers or employers at the time that nonqualified stock options are granted or at the time they vest; however, upon the exercise of a nonqualified stock option, the service provider is taxed at ordinary income tax rates on an amount equal to the difference between the fair market value of the stock at the time of exercise and the exercise price. The company receives a business expense deduction equal to the amount of ordinary income recognized by the service provider. Upon the disposition of the acquired stock, the service provider recognizes long-term capital gain equal to the difference between the fair market value of the stock at the time of disposition and the fair market value of the stock at the time the option was exercised—provided, however, that the service provider has held the stock for at least one year. Service providers who have held the stock for less than one year at the time of disposition will be taxed at short-term capital gain rates.
In contrast to ISOs, which result in pure capital gain to the service provider, a portion of the service provider's gain from nonqualified stock options is taxed at the higher, ordinary income tax rates. The employer, however, has a potential tax advantage from nonqualified stock options as a result of the business expense deduction it receives for the portion of the gain deemed to constitute compensation to the service provider and taxed at ordinary income tax rates.
As compared to options, which are generally not deemed to be property,28 the taxation of restricted stock is controlled by IRC Section 83, which pertains to property transferred in connection with the performance of services. Property received in connection with the performance of services generally is not subject to taxation until it ceases to be subject to a substantial risk of forfeiture.29 A person's rights to property are subject to a substantial risk of forfeiture if the rights are conditioned upon the future performance of substantial services.30 Thus, the issuance of restricted stock does not result in any immediate federal income tax consequences.
Upon the vesting of the restricted stock and the concurrent lapse of the substantial risk of forfeiture, the holder of the restricted stock is subject to ordinary income tax on the difference between the fair market value of the stock at the time of lapse and the amount paid, if any, for the restricted stock.31 The employer receives a business expense deduction equivalent to the amount of ordinary income recognized by the holder of the restricted stock.32 Upon disposition of the restricted stock, the holder recognizes long-term capital gain equal to the difference between the fair market value at the time of disposition and the fair market value at the time the restriction lapsed—provided that the holder of the restricted stock has held it for more than one year from the date of grant.33 Service providers who dispose of restricted stock that has been held for less than one year will be taxed at the short-term capital gain rate.
Under certain circumstances, a recipient of restricted stock may prefer to be taxed at the time of its receipt rather than at the time the substantial risk of forfeiture lapses. For example, if a service provider is granted restricted stock at a time when the stock of the employer has an extremely low fair market value and the service provider expects the stock to appreciate substantially prior to the time the restriction lapses, the service provider may prefer to recognize the difference between the current fair market value and the price paid for the stock, if any, as ordinary income at the time of grant rather than recognize the difference between the presumably higher fair market value at the time the restriction lapses and the price paid for the stock, if any. The service provider is permitted to choose this immediate recognition of income pursuant to a Section 83(b) election.
If a recipient makes a Section 83(b) election, the excess of the fair market value at the time of transfer over the price paid, if any, for the property is included in the recipient's income at the time of transfer.34 A Section 83(b) election is made by filing a written statement with the office of the Internal Revenue Service to which the service provider files his or her return.35 The written statement must:
- Indicate that an election is being made under IRC Section 83(b).
- State the name, address, and taxpayer identification number of the taxpayer.
- Describe the property covered by the Section 83(b) election.
- Include the date on which the property was transferred and the taxable year for which the election is being made.
- Describe the nature of the restriction to which the property is subject.
- State the fair market value of the property at the time of transfer.
- State the amount, if any, that was paid for the property.
- State that copies of the written statement of election have been provided to the appropriate parties.36
A copy of the written notice must be attached to the service provider's tax return for the year in question.37 In addition, the person who performs the services must submit a copy of the written statement to the employer.38 The election must be made within 30 days of the service provider's receipt of the restricted stock and is irrevocable.39 Thus, if a service provider makes a Section 83(b) election and subsequently forfeits the restricted stock, the service provider is precluded from backing out of the transaction or taking a deduction or loss in the amount of the gain previously recognized as a result of the election.
At the time a service provider disposes of property for which a Section 83(b) election was made, the transferee recognizes long-term capital gain equal to the difference between the fair market value of the stock at the time of disposition and the fair market value of the stock at the time of grant—so long as the service provider has held the stock for at least one year.40 A service provider who has made a Section 83(b) election and disposes of restricted stock held for less than one year will be taxed at short-term capital gain rates.
Equity compensation is not merely a product of the recent boom in technology stocks. It has long been a method of placing golden handcuffs on key personnel by tying their financial interests to the success of the employing company. The recent dot-com and technology stock craze, however, has popularized the mass use of stock options and restricted stock as mechanisms to lure talented individuals toward risky business ventures and then to induce them to stay.
Some business commentators criticize the widespread use of incentive stock awards and equate the lure of stock options to the Gold Rush of 1849. These commentators hypothesize that while everyone is rushing to strike it rich by joining a company that will grant them stock options, only those companies with solid business plans underlying their stock options will actually turn out to be gold mines for the avid speculators. These same commentators are concerned that weak business ventures are drawing needed employees away from traditional service industries with the promise of vast financial rewards that may not materialize—and the individuals drawn by the expected wealth instead of a commitment to the venture itself will leave for greener pastures.
In light of the instability of technology stocks in recent months, it appears that many of these predictions have come to pass. Professional recruiters are reporting vastly increased demand for their services as service providers decide to forgo worthless stock options for a new opportunity. Regardless of the long-term effects of the surge in equity compensation on the market, it is clear that equity compensation is currently preferred over enormous salaries as a mechanism to retain talent in the technology arena.
1 Even landlords in areas with a high density of dot-coms have begun to demand equity compensation from start-up companies in lieu of traditional rent.
2 SEC Rules §230.701(c). In order to qualify for the federal and California securities transaction registration exemptions, all consultants and advisers who receive stock pursuant to a stock incentive plan must be natural persons and provide bona fide services to the issuer or its affiliates. SEC Rules §230.701(c).
3 Cal. Code Regs. §§260.140.41(a), §260.140.42(a).
4 SEC Rules §230.701(c).
5 Cal. Code Regs. §§260.140.41(e), 260.140.42(d).
6 Cal. Code Regs. §§260.140.41(h), 260.140.42(e).
7 Cal. Code Regs. §§260.140.41(i), 260.140.42(f).
8 Cal. Code Regs. §260.140.46.
9 SEC Rules §230.701(d)(2).
10 SEC Rules §230.701(d)(3)(iii). Thus, in determining the amount of outstanding securities for the purpose of establishing the aggregate value of securities that may be granted under a stock incentive plan, vested but unexercised stock options are included.
11 Cal. Code Regs. §§260.140.41(b), 260.140.42(b)(1).
12 Cal. Code Regs. §260.140.41(b).
13 Cal. Code Regs. §260.140.42(b)(2).
14 Cal. Code Regs. §260.140.41(c).
15 Cal. Code Regs. §§260.140.41(d), 260.140.42(c).
16 Cal. Code Regs. §260.140.41(f).
17 Cal. Code Regs. §260.140.41(g).
18 I.R.C. §422(b).
19 I.R.C. §422(b)(1).
20 I.R.C. §422(b)(2)-(5).
21 I.R.C. §422(c)(5).
22 I.R.C. §422(b).
23 I.R.C. §422(d).
24 I.R.C. §422(d)(3).
25 SEC Rules §230.701; Cal. Code Regs. §§260.140.41, 260.140.42.
26 I.R.C. §421(a). However, the excess, if any, of the fair market value of the stock on the date of exercise over the exercise price will be treated as a tax preference item for federal income tax purposes and may subject the optionee to the alternative minimum tax in the year of exercise.
27 I.R.C. §422(a). If the disposition of the option fails to meet these requirements, the option fails to constitute an ISO. However, in the case of death or disability, the time frame during which the optionee must have been an employee of the issuing corporation or a parent or subsidiary of the issuing corporation runs from the date of grant of the option to the date ending one year before the date of exercise of the option. I.R.C. §422(c)(6).
28 I.R.C. §83 only applies to the transfer of an option if the option had a readily ascertainable fair market value at the time the option was granted. Options have a readily ascertainable fair market value if the option itself, as opposed to the underlying security, is actively traded on an established market, or if the taxpayer can show that:
- The option is transferable by the optionee.
- The option is immediately exercisable in full by the optionee.
- The option or the property subject to the option is not subject to any restriction or condition that has a significant effect upon fair market value.
- The fair market value of the entire option privilege can be measured with reasonable accuracy, taking into account such factors as 1) whether or not the value of the property subject to the option can be ascertained, 2) the probability of the property's ascertainable value increasing or decreasing, and 3) the length of the period during which the option can be exercised.
Inasmuch as it is extremely difficult to demonstrate that these conditions have been met in any particular case, an option rarely has a readily ascertainable fair market value. Treas. Reg. §1.83-7(b).
29 I.R.C. §83(a).
30 I.R.C. §83(c)(1).
31 I.R.C. §83(a).
32 I.R.C. §83(h).
33 I.R.C. §1001.
34 I.R.C. §83(b).
35 Treas. Reg. §1.83-2(c).
36 Treas. Reg. §1.83-2(e).
37 Treas. Reg. §1.83-2(c).
38 Treas. Reg. §1.83-2(d).
39 I.R.C. §83(b).
40 I.R.C. §1001.
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