Here’s what you need to know about stock option com­pen­sa­tion strate­gies.

Grow Your Business, Not Your Inbox

Stay informed and join our dai­ly newslet­ter now!


5 min read

Opin­ions expressed by Entre­pre­neur con­trib­u­tors are their own.


Stock option com­pen­sa­tion strate­gies are hard for small firms and star­tups to get right even in the best of times giv­en the myr­i­ad of rules that apply. The Covid-19 cri­sis has made it hard­er, under­lin­ing the impor­tance of smart plan­ning around equi­ty-based pay to avoid unex­pect­ed tax out­comes for com­pa­nies and employ­ees.

One prob­lem is the mar­ket volatil­i­ty that has accom­pa­nied the pan­dem­ic, and the poten­tial for more to come. Depend­ing on where the options were priced when they were issued, this could either result in a lack of incen­tives for employ­ees because their options are severe­ly “under­wa­ter” or an unex­pect­ed­ly large wind­fall for them that could hurt cur­rent share­hold­ers.

The oth­er com­pli­cat­ing fac­tor is the gen­er­al uncer­tain­ty over how key parts of the will recov­er. That’s mak­ing it unusu­al­ly hard to arrive at an accu­rate val­u­a­tion, which usu­al­ly deter­mines the strike price for . Val­u­a­tions are usu­al­ly dri­ven by cash flow, which for many firms has evap­o­rat­ed or become high­ly errat­ic since March.

This can be espe­cial­ly dif­fi­cult for tech star­tups, which rely heav­i­ly on stock options to incen­tivize their staffs when cash is in short sup­ply. Unlike more estab­lished firms, they often lack the resources to thor­ough­ly ana­lyze the com­plex tax and reg­u­la­to­ry issues around stock options that could come back to bite them and their employ­ees.

The fol­low­ing are three key things that com­pa­nies should be con­sid­er­ing about stock options right now.

1. Avoid valuation risks

Com­pa­nies need to pro­tect them­selves and stock option recip­i­ents from the poten­tial­ly dire tax con­se­quences of issu­ing options with a strike price that is low­er than the cur­rent fair val­ue of the stock. One way to avoid these dire con­se­quences is for com­pa­nies to obtain a Sec­tion 409A val­u­a­tion. Still, many star­tups take a casu­al or over­ly aggres­sive approach on val­u­a­tion in order to save the cost of a val­u­a­tion or to boost incen­tives for employ­ees. If that gets uncov­ered in an audit, employ­ees could be on the hook for extreme­ly heavy penal­ties and the com­pa­ny could suf­fer a rep­u­ta­tion­al blow as well as fur­ther tax con­se­quences. Although a Sec­tion 409A val­u­a­tion can be done in-house, the safest way is to hand the task to a third-par­ty apprais­er with expe­ri­ence in this area. One big advan­tage of using a qual­i­fied third par­ty is rather than you hav­ing to prove that the val­u­a­tion is rea­son­able, it puts the bur­den on the IRS to prove your val­u­a­tion is unrea­son­able.

2. Pick the right option

Choos­ing the right form of stock options is anoth­er area that many com­pa­nies don’t put enough thought into, result­ing in tax out­comes that can under­mine their incen­tive strate­gies. The two main types – incen­tive stock options (ISOs) and non-qual­i­fied stock options (NSOs) – come with very dif­fer­ent tax con­se­quences and many poten­tial out­comes depend­ing on how employ­ees exer­cise them. In gen­er­al, NSOs are treat­ed as ordi­nary income for employ­ees and deduc­tions for employ­ers when they are exer­cised. Star­tups often see ISOs as a bet­ter incen­tive tool because the pro­ceeds can be taxed at the low­er cap­i­tal gains rate at the time the under­ly­ing stock is sold rather than as ordi­nary income at exer­cise, so long as employ­ees do not sell the stock before the lat­er of two years after the grant date and a year after the exer­cise date.

3. Know the tax landscape

Things can get com­pli­cat­ed if, as is com­mon, com­pa­nies allow employ­ees to con­duct a “cash­less exer­cise” of ISOs, in which some options are sold in order to fund the exer­cise of the rest. That results in a “dis­qual­i­fy­ing dis­po­si­tion” that requires the pro­ceeds to be taxed as ordi­nary income and is report­ed on the employee’s W‑2 form. Oth­er com­pli­cat­ing fac­tors about ISOs that need to be con­sid­ered are the Alter­na­tive Min­i­mum Tax pref­er­ence and the $100,000 annu­al lim­it. The lat­ter can be a big obsta­cle in com­pa­nies that expect to have a very strong growth tra­jec­to­ry. ISOs are also often issued in sce­nar­ios where they are unlike­ly to be exer­cised until an exit event is immi­nent, caus­ing the antic­i­pat­ed tax ben­e­fits to be lost. While ISOs can be pow­er­ful plan­ning tools, they are sim­ply not always the best choice in many fact pat­terns.

These are just some of the impor­tant points to con­sid­er in what is a very com­plex tax area strewn with pit­falls.

Each com­pa­ny will need a tai­lored solu­tion to suit its stage of devel­op­ment, its growth plan, its com­pa­ny cul­ture, and its tal­ent require­ments. Com­pa­ny lead­ers need to under­stand the dif­fer­ent options and the best fit for the firm. They then need to com­mu­ni­cate to employ­ees and help guide them through the risks and oppor­tu­ni­ties from dif­fer­ent choic­es.

Kurt Piwko is a Part­ner in Plante Moran’s Nation­al Tax Office. Michael Kruck­er, a Part­ner in Employ­ee Ben­e­fits Con­sult­ing at Plante Moran, also con­tributed to this arti­cle.     

 

Source link