Sharing the Wealth Can Retain Stellar Employees
July 1, 2008
Ownership incentives — elite executives won’t consider a job offer without them and employees of every stripe often feel greater motivation and investment in the company with them.
Such incentives, whether in the form of stock options or a profits interest, are attractive for deserving employees but can be quite complicated to implement, especially for large or publicly traded companies.
“Depending on the size of the company, the incentive type will become more complex,” says Brent Andrewsen, chair of the corporate and tax section of Kirton & McConkie. “But once you know exactly what you want to accomplish and you get the right legal and tax advice, it’s just a matter of jumping through the right hoops.”
And there are many hoops. When implementing an ownership incentive program, companies must consider tax implications as well as compliance with securities and business laws that may mandate shareholder-approved plans, certain disclosures and the protection of minority owners.
Stock options are perhaps the most well known of ownership incentives. “The advantage of a stock option plan is that you can give executives the option to buy stock at some future date at no cost to the executive until he or she decides to exercise the options,” says Bruce Babcock, past chair of the business department of Jones Waldo Holbrook & McDonough.
Stock option plans can be constructed in a number of ways. In a non-qualified stock option plan, employees are given an option to purchase company stock at a set price after a specific future date. When initially granted, the option price must be equal to or greater than the fair market value of the stock.
And taxes? In a non-qualified stock option plan, the employee must pay income tax based on the profit gained in the exercise of the options (the current fair market value minus the reduced stock option price).
The tax implications are different for qualified stock options, also known as incentive stock options (ISOs). “The employee has to come up with the money to exercise the option, but the advantage is there is no taxable event when you exercise the option,” says Babcock. Instead, the employee must pay long-term capital gains tax upon selling the stock.
For a qualified stock option plan, a company must have a shareholder-approved plan that takes into account various securities regulations. To protect minority investors, limits are often placed on how many options employees may be given.
In a restricted stock incentive plan, employees are issued actual shares. However, the shares are only made available to an employee after a vesting period has elapsed. Companies can choose to give restricted stock to employees outright, offer it at a discounted price or sell it at the fair market value.
Bonus stock is considered income for tax purposes, says Babcock, which requires employees to come up with an out-of-pocket payment during income tax season — an unpleasant shock for unsuspecting employees. And if discounted shares have gone up in value after the vesting period, the difference in value is also taxable as income.
“There’s a trend away from non-qualified stock options and towards restricted stock because there is less regulation and oversight,” says Babcock.
Closely Held Companies
Awarding ownership to employees can be a bit more complicated for small, closely held companies. The primary difficulty, says Andrewsen, is accurately assessing the value of company shares in the absence of a fair market value.
When employees are given shares or receive them at a reduced price, they must pay income tax, so the value of the shares must be determined precisely. Consequently, well-meaning companies should consider the tax implications of gifted shares for employees. “Free stock can turn out to be very expensive for an employee,” says Andrewsen.
All of this sounds very complex, says Andrewsen, but “there’s nothing wrong with simply selling a percentage of the company to an employee.”
Figure out how you want to reward employees with ownership incentives, then get advice from legal and accounting experts. “When you know the rules of the game, they’re not that difficult to follow,” says Andrewsen.