Here’s what you need to know about stock option compensation strategies.
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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 economy will recover. That’s making it unusually hard to arrive at an accurate valuation, which usually determines the strike price for stock options. 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 IRS 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.