Successful businesses will have successful, driven, and strong employees. Often businesses are faced with questions and issues regarding maintaining employees, hiring the right employees, and incentivizing employees. Incentive compensation arrangements are often used by large and small businesses as a means by which to reward employees, as well as a benefit to individuals the business is hoping to hire and maintain. An incentive compensation plan can have a number of benefits over cash compensation and qualified plans such as:
- They can be easy to adopt, with low upkeep and administrative costs
- Employees can defer taxation
- The plan can allow a key employee to participate and share in corporate growth through direct equity ownership, or grant equity flavored compensation such as phantom stock
- Incentive compensation plans do not need to meet discrimination requirements, whereas qualified plans may need to meet such requirements
A small business such as an S corporation can use an incentive plan just like a C corporation, but one must be mindful of the S corporation eligibility rules. The eligibility rules for an S corporation create matters and issues that must be considered when an S corporation implements an incentive compensation plan. This article has been prepared by a business attorney and tax attorney to provide information regarding stock options available to small businesses when implementing an incentive compensation plan.
Stock options can be used by corporations to compensate certain key employees. There are two forms of these stock options: 1) Nonqualified Stock Options (NQSOs) and 2) Incentive Stock Options (ISOs).
A Nonqualified Stock Option is an option granted by the corporation to an employee. The option provides the employee with the right to purchase corporate stock at a specific and designated price through some date established in the future. Generally, the option will grant an executive or key employee the ability to purchase stock at a price that is below fair market value. For example, John, a highly trained & key employee of Do It Right, Inc. may receive an option to buy shares at $15/share, when the fair market value of the share is $30/share through a certain date in the future. After a specific holding period, the option can be exercised, or it may vest in steps or stages in the future.
Options are not taxed at the date they are granted under Section 83 of the Internal Revenue Code unless there is a readily ascertainable fair market value. Generally, treasury regulations would hold that an option not actively traded on a market does not have an ascertainable fair market value unless the value can be determined with reasonable certainty. Therefore, generally, the regulations presume an untraded option would not have a readily ascertainable fair market value. It also can be relatively safe to assume that S corporation options would rarely have an ascertainable fair market value and therefore, the option would not be taxed until exercised. When exercised, the difference between the stock’s fair market value and the amount paid by the employee in exercising the option are taxed to the employee as compensation, and the employer is permitted a deduction for compensation.
Incentive Stock Options
An incentive stock option plan is similar to a nonqualified stock option in that it is an option purchase stock in the corporation at a future date. The difference is, the holder of an incentive stock option can receive preferential tax treatment upon exercising the option that is not available to the holder of a nonqualified stock option. The incentive stock option plan must meet very specific standards. Under IRC Section 422(b), the option must: 1) be granted to an employee via a plan approved by the shareholders; 2) have an exercise price not less than the stock’s fair market value as of the date of grant; 3) no longer than a 10 year exercise period, and be granted within 10 years; 4) restrictions on transferability; 5) the holder of the option, at the time the option is granted cannot own more than 10% of the combined total voting power of all corporate stock. The last issue #5, does not apply if the option price is at least 110% of the fair market value of the applicable stock when granted. When the requirements are met, the holder of the option can exercise the option free of tax! Yes, the holder postpones the taxable event until the stock received via the option is disposed of, sold, or exchanged.
John R. McGuire is a tax attorney and business attorney at The McGuire Law Firm. In addition to his J.D., Mr. McGuire holds an LL.M. in taxation. Mr. McGuire advises his clients on matters before the IRS, tax planning & issues, and business transactions from formation & sale to contractual issues.
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