Incentive compensation plans, stock option plans, and equity incentive plans help owners of private corporations to attract, retain, and incentivize key employees. They also aid in enhancing profits and building company value. The employees receive value through profit sharing and sometimes via appreciation of equity.
Stock option awards in a small business can result in value for employees when the business is sold. However, stock option plans realize no added value for employees when founders continue to hold the company or pass ownership to their family members and close associates. In those cases, companies need other forms of incentive compensation structures for their key employees.
When the ultimate goal is to sell the company, business owners need to consider how potential buyers will view their incentive plans. Buyers realize they cannot take benefits away from critical employees and keep them happy, which means they will likely have to continue the current incentive plan or replace it with some other form of compensation those employees will value.
Related: Equity Compensation.
Types of Incentive Compensation Plans
Restricted Stock Grants: Business owners grant employees restricted stock which becomes available under a graded vesting schedule that lasts for many years. Limited stock is non-transferable and subject to forfeiture upon termination of employment, failure to meet performance benchmarks, and other conditions as specified. They are treated as total stocks for dividend purposes and voting rights.
Restricted Stock Units (RSUs): Similar to local stock grants, restricted stock units differ in business owners making an unsecured promise to grant a certain number of shares of stock to selected employees after the vesting schedule is complete forfeiture requirements are met. As no stock is issued during the vesting period, RSU participants do not have voting rights. Disbursement of dividends to employees depends on the type of RSU plan. Sometimes employers may pay cash instead of stock.
Stock Appreciation Rights (SARs): This type of incentive compensation plan links to the company’s stock price. Employees gain when the stock price rises during a predetermined period. Employees need not own a contract or asset to receive stock appreciation proceeds in the form of stock or cash. SARs benefit business owners, as they don’t have to issue additional shares, which results in diluting share price.
Profits Interest: Profits interest is the closest equivalent to a stock option for limited liability corporations. An LLC can grant profits interest to employees or other individuals. The recipient gets the interest in the future profits of the LLC and the appreciation of its assets.
Phantom Stock Plans: Phantom stock plans provide employees with awards measured by the increase in the value of the company’s stock. However, the recipients of these units of interest do not get equity ownership in the company. Sometimes, a phantom stock plan is also called shadow stock as the employees get “mock stock” instead of actual shares.
Bonus Compensation Plans: Companies may consider bonus compensation plans in place of awarding stock to employees. Bonus compensation entails the lump sum payment of money in addition to the salary an employee earns.
Stock Option Types
There are two main stock options: non-qualified or non-statutory stock options (NSOs) and incentive stock options (ISOs). The main difference between them concerns how and when they’re taxed.
Stock option plans are a type of equity compensation commonly used by corporations to incentivize employees and attract top talent. With a stock option, the recipient can buy shares of common stock after earning the right to exercise those options (becoming vested) at a pre-determined price, called the exercise price. At the time of grant, the company must set the exercise price at the fair market value of the common stock.
Non-qualified or Non-statutory Stock Options (NSOs)
An NSO holder pays tax at ordinary income tax rates at the time of exercising the option. The tax is applied on the excess of the fair market value of the stock that the NSO holder receives while exercising the option over the exercise price and any amount the employee paid for the option.
Taxable Amount = Fair Market Value – (Exercise Price + Option Price Paid by the Employee)
However, since an employee usually pays nothing for the stock, the tax is generally imposed on the excess of the stock’s fair market value at the time of exercise over the exercise price. Therefore, the NSO holder needs to pay federal income tax, state income tax (if any), Social Security tax, plus the Medicare tax under the Affordable Care Act. If the employee sells the stock for more than the value of the stock at the time of exercise, then the IRS treats this further appreciation as a capital gain.
If the employee holds the stock for at least one year from the time of exercise, the IRS treats this further appreciation as a long-term capital gain taxed at a lower long-term capital gains rate. Again, state income taxes (if any) would apply even for such long-term capital gains, but Social Security taxes would not.
Incentive Stock Options (ISOs)
For an NSO to qualify as an ISO, it must meet several requirements, including:
- The company must grant this option to people connected with employment, meaning employees can receive ISOs, but not contractors.
- The corporation must grant the option within ten years from the earliest date the board adopted the plan, or the shareholders approved it.
- The ISO grant specifies a minimum period for inauguration during which the option cannot be exercised.
- At the time of granting the option, the option price or the exercise price cannot be less than the stock’s fair market value.
- The option cannot be transferred, except in the case of the ISO holder’s death.
- A single option recipient cannot own more than 10% of the issuing corporation or its subsidiary’s voting stock at the time of grant unless specific rules are satisfied, including an exercise price at least equal to 110% of the fair market value.
- The aggregate fair market value at the time of stock grant that is first exercisable during any calendar year cannot exceed $100,000. If this $100,000 rule is violated, the excess above $100,000 is treated as nonqualified stock options.
- The employee must remain in employment from the option grant until three months before exercising the option.
- The plan should meet specific requirements, and the shareholders must approve them.
On the sale of the stock acquired upon exercise of the ISO, the employee realizes a long-term capital gain or loss after meeting holding period requirements. The long-term capital gain rates are 15% or 20%, and Social Security taxes do not apply.
Despite the usually favorable treatment, Alternative Minimum Tax (AMT) applies to ISOs on the spread realized on exercise. However, the taxpayer can reduce the overall AMT burden by leveraging an AMT credit for future years and offsetting tax at that time.
From a tax perspective, ISOs may be less beneficial to the company than NSOs, as the company may deduct the compensation expense associated with NSOs but not ISOs. To qualify for ISO tax benefits, the employee must continue to own the shares two years after the ISO grant or one year after the ISO exercise. If the employee sells the shares before the holding period, he receives ordinary income equal to the lesser spread during the ISO exercise and the gain from stock disposition.
A company can grant both ISOs and NSOs under a single stock option plan.
Employers use many varieties of incentive compensation plans which help incentivize critical employees to put forth more effort, be more productive, and think more holistically about the business.
Stock option plans or equity incentive plans encourage longer-term thinking and behaviors that increase enterprise value. Assuming there is an exit strategy, such programs allow employees to defer compensation into the future. If the business value of the company increases, the plans create incentives for employees to stay. This enables the company to compete with both private and public companies for talent.
The correct form of an incentive compensation plan and the proper structure can vary greatly, depending on the unique goals and needs of different types of companies. Business owners can work with experienced value advisors to evaluate and choose the plan that best suits their situations.