A couple of weeks ago we looked at capitalization of your company through the offer and issuance of stock, and how state and federal securities laws can impact such a plan.  Having discussed the regulatory impact of equity interests, let’s shift gears and look at the tax impact of using equity as an employee benefit.

Maybe  you’ve got an employee who is really indispensable to your business — someone who brings a lot of value, whom you don’t want to lose.  Or maybe you’re trying to attract just such a person to your company; perhaps a Chief Executive Officer, Chief Operations Officer, Chief Technology Officer, or other C-suite type of executive.  Or maybe a hard-to-find computer programmer with just the skills you need for your project.  As an incentive to jump on board (for a new employee), or perhaps as incentive to stay on board (for current employees), you decide to offer equity in your company, usually (but not always!) in the form of stock.

This is a very common and effective tactic for attracting and keeping the best people for a particular business, but as you might expect it can come with some unexpected traps and pitfalls if you are not careful.  One of the most common and devastating problems can arise when the Internal Revenue Service decides that your employee has to pay taxes on the equity you have awarded him or her, even though the employee hasn’t gotten any cash at all out of it.

The rules regarding qualified and non-qualified stock plans and stock options are much too complex to even summarily discuss here, but let’s take a few minutes to look at a few very basic concepts.  Please be aware that the following discussion is very general, and based on a lot of assumptions and common scenarios — each individual circumstance can be very, very different, which is why it is imperative for you to consult with a knowledgeable business attorney before implementing any sort of incentive stock award.

First, you should understand that in the IRS’s eyes, equity has value, and thus must be taxed as income.  In short, if Bill Gates decided to give you $1 million in Microsoft stock, the IRS will require you to pay income tax on $1 million, even if you never sell a single share and all you have are a bundle of stock certificates.  So, on paper you are $1 million richer in assets, but you are absolutely no richer in terms of cash, which is the only currency the IRS will accept for payment of taxes.  How are you going to pay those taxes?

The same thing happens if you decide to give equity to an employee in order to get/keep them working for you.  Assuming there are no contingencies involved (i.e. the possibility that you can take the stock back — what we call “forfeiture”), when that equity is awarded (we call that “vesting”), your employee will have to pay income tax on the fair market value of the stock they received.  Where will they find the money (cash) to do that?  Be aware, though, that this is relevant if the equity is automatically awarded upon a certain triggering event occurring (i.e. meeting a certain goal, or working for the company for a certain period of time — frequently known as “golden handcuffs” — etc.).   These arrangements would most commonly be known as stock (or equity) “grants” or “awards.”

However, a very common alternative to a stock grant would be the stock option.  Usually, this gives the employee the right, upon the occurrence of the triggering event, to purchase a certain amount of stock at a certain price, rather than simply be given the stock.  Typically the employee is given the right to purchase the stock at a very low value (called a “strike price”).  That’s really where the benefit lies.  As of the date of this writing, Microsoft stock is trading at about $73 per share.  Who cares if I have the option of paying full price to purchase it?  But . . . if my stock options give me the right to purchase Microsoft shares at a strike price of $20 per share, then I have truly found a bargain!  So if today you give your employee the right in three years the right to purchase company stock at today’s prices, then you have quite possibly given that employee quite an incentive to stick around for at least three years (hopefully in three years the stock will have risen in value; your employee has significant incentive to ensure that it does!).

Now, of course, if your employee leaves the company before three years elapse, then they don’t have the option of purchasing their options, they don’t receive any income from the stock, and there is no tax.  Also, if the employee sticks around but simply never exercises their options, there is likewise no income, and no tax.  BUT . . . if the employee does exercise their options, then they will likely realize quite a gain, and they will have to pay income tax on that gain.  In the case of my Microsoft example above, if I were to purchase the stock at $20 per share when the fair market value is $73 per share, I have immediately realized $53 of income per share — and I will have to pay income tax on that.  The same would be true of your employee — if they exercise their right to purchase the company stock at a price lower than the fair market value at the time, they will likely have to pay income tax on that difference.  Of course, if the strike price (the price they pay for the stock) is the same or higher than the fair market value at the time, there would be no gain on the purchase, there would be no income, and there would be no tax due.  Got it?

Be aware that the foregoing is only the tip of the iceberg when it comes to employee stock incentives.  There are all sorts of regulations and alternatives related to qualified and unqualified options, stock plans, incentive stock options, phantom stock, profit-sharing, and so forth.  In some scenarios there are minimum holding periods (time periods that must elapse before the employee can sell their stock), as well as maximum exercise periods (time periods within which an employee must exercise their options, or lose them), and so forth.  Some incentive plans require formal company stock plans to be implemented, some do not; some regulate which employees can/must be offered the plan, some do not.  The bottom line is that if you run afoul of these regulations, your company, or your employee, or both may be on the hook for significant income taxes that your business — or your employee — may not have the cash to pay.  A knowledgeable business attorney can help you craft an employee incentive option that best fits your situation and minimizes — or at least manages — income taxes, using tactics such as employer financing of options, various types of forfeiture provisions, and much, much more.

Employee stock incentives are an effective tool.  But, as in medicine, the first rule needs to be “do no harm.”

#stockoptions