CFP Course 102 - Unit 8: Equity-Based Compensation NEEDS EDITING
substantial risk of forfeiture
substantial risk of forfeiture exists if the arrangement provides that the employee will forfeit the stock in any of the following circumstances. ■ The employee does not remain with the employer for a specified period. ■ The employee does not meet certain sales or performance goals. ■ The employee goes to work for a competitor. ■ The employee works for a corporation that is not controlled by immediate family members.
Gifting an NQSO
A viable planning technique is for the employee/executive to gift the NQSO to either a family member or qualified charity before the option's exercise date. In this manner, the employee recognizes no gain on the transfer date and may potentially remove the option and shares of stock from the taxable assets of the estate. However, when either the family member or qualified charity exercises the option, the employee will have W-2 compensa- tion income, which is a type of ordinary income, and this income will be subject to FICA or payroll taxes at the exercise date. If the donee is a qualified charity, the employee will be permitted a charitable income tax deduction on the transfer date (or the option's vesting date, if later).
Requirements and Taxation of an NQSO
If the NQSO does not have a readily ascertainable fair market value at the date of the grant (the usual case), the employee is not taxed until the date of the exercise of the option. On the exercise date , the bargain element represents income to the employee. The bargain element is the difference between the market value of the stock at any particular time and the option's exercise price. In the taxation of an NQSO, this bargain element is taxed at the date of the option's exercise as W-2 compensation income, which is a type of ordinary income, and is subject to payroll or FICA taxes (because the option was granted originally in lieu of salary compensation). The employer also receives a deduction for the amount of the bargain element when the employee brings the amount into income. The stock's holding period, for purposes of determining long- or short-term capital gains treatment to the employee, begins with the exercise date. The taxable basis in the stock is equal to the option's exercise price plus the ordinary income recognized on the exercise date.
phantom (shadow) stock arrangements.
Such arrange- ments are structured as fictional deferred compensation accounting entries where the base value is equal to the current value of the corporation's common stock. The plan then pro- vides for adjustments to the fictional entries to track the real appreciation of the corpora- tion's common stock. Each year, the employee/executive becomes vested in the shares, and lump-sum payments normally are made at the executive's retirement or some other specified event. The payment is made in the form of cash. The employee/executive is taxed as ordinary income tax rates when payment is received at retirement or some other event, and the employer receives an income tax deduction at that time. The major drawback to establishing a phantom stock plan involves having to determine a value for the closely held stock at various times. These frequent appraisals of stock value can be expensive for the closely held business, not to mention the extreme volatility of actual value given the unexpected death, disability, or retirement of an owner or owners of the business.
Section 83(b) election
an employee who receives restricted stock may elect to recognize the compensation (W-2) income immediately rather than wait until the substantial risk of forfeiture expires. If this election is made within 30 days of receiving the restricted stock, the employee includes as W-2 income the FMV of the stock at receipt less any amount paid for the stock. As a result of this election, any subsequent appreciation in the value of the stock is treated as a capital gain and may be taxed at lower capital gain rates when the stock is sold. Nonetheless, as a financial planner, you should not tell your executive client to auto- matically make the Section 83(b) election with respect to restricted stock. If the executive makes the Section 83(b) election and then forfeits the stock (for whatever reason), he is not allowed a deduction or refund of tax paid on previously reported income. In addition, if the executive has paid no money to acquire the restricted stock, he will not realize a capital loss when the substantial risk of forfeiture expires.
Junior class shares (JCSs)
are a separate class of common stock whose voting and divi- dend rights are subordinate to the regular class of common stock issued by a corporation. JCSs are typically convertible into regular shares upon certain specified events, such as the attainment of performance goals by the employee. Conversion may be automatic if stated in the issuing document or at the option of the employee. JCSs are similar to NQSOs, but JCSs are taxed more favorably. Although both JCSs and NQSOs give employees the right to acquire company stock at a price below FMV, the employee receiving JCSs is not taxed on the date the JCSs are converted to regular common shares. Rather, taxation is deferred until the sale of the regular shares, and the difference between the sale price of the stock and the employee's basis in the stock (what was paid for the JCSs, if anything) is taxable as a capital gain.
Stock appreciation rights (SARs)
are similar to phantom stock plans except that SARs give the employee/executive a choice of when to exercise the right to share in the apprecia- tion of the closely held company's stock. In addition, with SARs, only the appreciation on the stock is awarded (not the full value of the stock as in a phantom stock arrangement). You should also note that SARs are used heavily by closely held businesses that are unable to offer traditional forms of ownership, such as limited liability companies (LLCs) and/or S corporations, which are restricted from having more than 100 shareholders/owners by law.
Stock options
give the employee (usually an executive) the right to purchase a fixed number of shares of employer stock at a predetermined price over a stated period. The grant or award of a stock option is generally a nontaxable event because the option's exercise price is usually equal to the stock's trading price on the day of the award. The option, therefore, has no readily ascertainable value, and there is no economic benefit to the employee to tax. The two types of stock options are nonqualified stock options (NQSOs), which are not tax-qualified, and incentive stock options (ISOs) or statutory options, which are tax- qualified. For reasons that will be discussed, the more popular type of option today is the nonqualified or regular stock option.
A cashless exercise of either an NQSO or an ISO
involves the selling of employer stock (rather than a cash outlay by the employee) to satisfy the exercise price and any other costs associated with the exercise, such as income taxes. As a result, the employee receives the net amount of the stock (the stock remaining after the sale of shares) or all cash. This technique is normally suitable for employees who do not have enough cash to satisfy the exercise price and any other costs associated with exercising the option.
Restricted stock
is employer stock (not a stock option) that is forfeited by the employee/executive if the employment performance is not satisfactory or if employment terminates before a requisite period. In IRC Section 83, which specifies the tax treatment of the arrangement, these accompanying restrictions before the stock vests (becomes non- forfeitable) are known as a substantial risk of forfeiture. Accordingly, the value of the stock will not be subject to income tax as long as the stock is subject to a substantial risk of forfei- ture. When the stock is no longer subject to a substantial risk of forfeiture, the value of the stock (less any amounts paid for the stock by the employee) is taxed as compensation (W-2) income to the employee.
Employee stock purchase plans (ESPPs)
plans that provide employees with options to purchase employer stock through payroll deductions. In addition to other requirements, the plans must be nondiscriminatory and often limit the amount of employer stock that an employee can actually purchase. However, if the plan meets all the necessary requirements, there are no income tax implications to the employees at either the grant or exercise date of the options.
ESPPs are generally intended for rank-and-file employees. The plan must be nondiscriminatory. All employees must be included in the plan, except the following:
■ Employees with less than two years of employment ■ Highly compensated employees ■ Part-time employees and seasonal workers The tax treatment of ESPPs is as follows: ■ The employee will recognize ordinary income based on the lesser of the FMV of the stock at the grant date less the option price, or the FMV of the stock on the disposi- tion date (or date of death, if sooner) less the option price. ■ The balance of any gain is treated as capital gain. ■ If the option price is equal to the FMV of the stock at the date of grant, all gain at disposition will be capital gain (if the shares are held by the employee for at least two years from the grant of the option and one year after the exercise).
requirements must be met under the Internal Revenue Code for a stock option to qualify for tax-favored status as an incentive stock option (ISO). These require- ments are also referred to as the special holding period rules and include the following
■ The ISO must be part of a written plan approved by the stockholders of the corporation. ■ The exercise date of the option cannot exceed 10 years from the date of its grant. ■ The exercise price of the option cannot be less than the market price of the stock at the date of the grant. ■ There is an annual limit of $100,000 on the value of the ISOs granted in any one year to the employee. ■ The shares received through the exercise of the ISOs cannot be sold within two years from the date of the option's grant and one year from the date of the option's exercise, otherwise the favorable tax treatment will be lost.
formal requirements of an ESPP a
■ The plan must be a written plan approved by the shareholders. ■ The option grant price must not be less than the lesser of: — 85% of the fair market value on the grant date, or — 85% of the fair market value of the stock on the exercise date. ■ No employee can acquire the right to buy more than $25,000 of stock per year, valued at the time the option is granted. ■ The shares acquired must be held by the employee at least two years from the date of the grant of the option and one year from the date of the exercise. ■ If the employee does not remain employed by the company, any outstanding stock options must be exercised within three months after leaving the company. ■ Employees owning more than 5% of the corporation may not participate in the plan.
In exchange for the satisfaction of these requirements, ISOs receive favorable income tax treatment, as follows.
■ There is no regular taxable event at the ISO's exercise date. However, an individual alternative minimum tax (AMT) event occurs, whereby the employee must report the bargain element of the ISO as of the exercise date as an AMT adjustment item. The AMT is a system designed to ensure that individuals with large deductions and other tax benefits pay at least a minimum amount of tax. Generally, regular income tax is reported on Form 1040 as a starting point. Form 6251 is used to report the AMT if necessary. (The individual AMT will be discussed further in the 104 Income Tax Planning course of this program.) ■ The employee's taxable basis for regular income tax purposes is the ISO's exercise price. For AMT purposes, this basis is the ISO's exercise price plus the bargain ele- ment. You should also note that the employer does not receive an income tax deduc- tion when the employee exercises an ISO. This is also the case if the employee satisfies the special holding period rules at the date of sale. In other words, it is possible that the company granting an ISO may never receive an income tax deduction. ■ If the stock acquired by exercise of the ISO is not sold until after one year from the date of the option's exercise and two years from the date of its grant, any gain in the value of the stock is treated as a long-term capital gain to the employee. Additional Medicare tax may apply to the transaction. ■ If the employee sells the stock within one year after exercise, or two years from the date of the ISO grant, the bargain element, which is the difference between the fair market value of the stock on the date of exercise and the option price, is taxed as ordinary income, reported by the employer on the employee's W-2 but is not subject to FICA or payroll taxes. If the stock has appreciated beyond the FMV at the date of exercise, then the remaining gain would be capital gain (usually short-term, depending on how long the stock was held before disposition). The difference between the option price and the fair market value on the date of exercise is an add-back for purposes of the alternative minimum tax (AMT).
