There are significant differences in the taxability of stock grants vs. stock options:
- Stock Grants – Stock grants are taxable to the recipient and deductible by the employer when there is no longer a substantial risk of forfeiture (i.e., upon vesting). The employee recognizes ordinary income based on the value of the stock received as of the vesting date.
The recipients of stock grants often consider whether an 83(b) election should be made, which allows the recipient to report as ordinary income the value of the stock received on the grant date rather than the vesting date. Although this accelerates the recognition of income, it allows for a larger portion of the company’s appreciation to be taxed as capital gains rather than ordinary income (assuming the company appreciates in value over time).
However, there are significant risks associated with making an 83(b) election. If a company’s value declines between the grant date and the vesting date the recipient will have recognized a greater amount of ordinary income (and paid the related tax) than the actual value of the stock as of the vesting date. An even more onerous issue arises if the recipient makes an 83(b) election and then does not ultimately vest in the shares of stock granted (e.g., if the employee quits or is terminated prior to the shares vesting). In that case, the recipient ends up recognizing ordinary income (and paying the related tax) on the value of stock that he or she never actually received and no related loss deduction is available to offset the accelerated income recognition.
- Stock Options – There are two types of stock options for tax purposes – Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NQSOs). Generally, ISOs offer superior tax benefits to employees, but are not as tax-beneficial to employers and have more issuance restrictions than NQSOs.
Ensuring compliance with IRS Section 409A (“409A”) is even more important than deciding between the issuance of ISOs or NQSOs Section 409A precludes the issuance of options with a strike price/exercise price less than the fair market value of the underlying stock on the grant date. This is the most significant risk associated with stock options from a tax perspective. Any deferred compensation (the spread between the exercise price and the fair market value of the stock) under 409A would be taxable to the recipient at ordinary income rates plus a 20% penalty and interest.
Employers could also be liable for penalties associated with under withholding payroll taxes on the deferred compensation amount. Given the significant tax consequences associated with non-compliance with 409A, it is important that all parties involved with the issuance of stock options for privately-held companies (for which an underlying stock price may not be readily available without a business valuation being performed) are satisfied with the documentation to support the fact that the strike price is equal to or greater than the underlying share value.
The similarities and differences between ISOs and NQSOs are summarized in the chart below:
Stock Options and Grants – Takeaways and Suggestions
The issues surrounding stock options and grants can be complex and impact the issuer and recipient from a number of different standpoints – legal, accounting, tax and valuation. Therefore, it is important to consider the effects of issuing equity-based compensation from each of these perspectives in order to ensure that the desired outcome is achieved. A few of the key takeaways and suggestions to keep in mind when drafting stock option and grant agreements are:
- Make sure your clients are aware of the accounting and valuation requirements that are necessary when stock options and grants are issued
- Put procedures in place to ensure that stock options are in compliance with 409A and are not issued with a strike price that is less than the fair market value of the underlying stock on the grant date
- Discuss with your clients and their accountants the tax impact of various equity-based compensation alternatives before granting shares or stock options
- Share draft stock option and grant agreements with the client’s accountant to determine if there are any unexpected accounting or valuation issues that may need to be addressed
Continue reading about the key accounting, tax and valuation considerations of buy-sell agreements in our e-book: Drafting Considerations for Attorneys: Buy-Sell Agreements, Accounting, Tax, and Valuation Issues. Click here to download your free copy.
To learn more about how a business is valued or to gain insight on the financial and economic issues that affect today’s business world, call the experts in the Valuation and Litigation Support group at 440-449-6800. Please email Sean Saari if you would like to learn more about buy-sell valuation considerations.