Below, we’ll share the basic features of several different incentive plans and identify some of the design issues that should be considered in establishing such a plan. This information is tailored to companies organized as corporations; however, similar concepts apply to companies organized as LLCs.
The purpose of long-term incentive plans is to encourage optimal performance of your employees, consultants and/or directors by compensating them with various types of awards that correlate their interests with those of the company.
The types of awards that may be granted under a long-term incentive plan include:
We will not be addressing employee stock purchase plans, employee stock ownership plans (ESOPs), or dividend equivalent rights because they are not typically used for privately-held companies. If you are interested in more information about those types of incentives, please contact a member of our Corporate team.
A stock award is a grant by a corporation to an employee of shares of stock of the employer or its parent or subsidiary. Stock awards are usually subject to certain securities/transfer restrictions, but not vesting conditions based on continued employment or performance goals. Thus stock awards are typically considered fully vested on grant.
The principal benefit of a stock award is that it grants an ownership interest in the corporation, which correlates the interests of the recipient to those of other stockholders. Another benefit is that stock awards usually result in less dilution than option awards (see below), because stock awards typically represent fewer shares than options, given their immediate value. Finally, stock awards are never “underwater,” which occurs when the fair market value of the stock underlying a stock option is less than the exercise price of the option.
Restricted Stock. Restricted stock is a grant of stock that is subject to certain restrictions. Restricted shares of stock are generally restricted in two ways. First, the stock is forfeited if service requirements, performance goals or other vesting conditions are not met. Second, the participant’s ability to assign, sell or otherwise transfer the shares is limited.
Most restricted stock awards are granted under a restricted stock plan or an omnibus equity incentive plan like your Plan and the material terms of each grant are set out in a restricted stock award agreement entered into by the company and the participant, such as the draft we prepared for your use with contractors.
On the grant date, grantees become the owners of record of the shares and have voting, dividend and other stockholder rights. However, the shares are non-transferrable and subject to forfeiture until the restricted stock vests (meaning, until the restrictions lapse). If the vesting conditions are not satisfied, the shares are forfeited. Restricted stock customarily vests when there is either:
Shares of restricted stock are issued in full at the time of the grant. The shares ordinarily have no purchase or exercise price and provide immediate value to the grantee. Therefore, the awards have no risk of going “underwater.” Restricted stock is considered a transfer of restricted property at the time the award is made which means that holders can elect to be taxed on the grant date under Internal Revenue Code (IRC) Section 83(b) (generally a tax-advantaged election for the holder assuming a low stock value upon grant, although not without risk since a subsequent forfeiture of the shares does not permit a deductible loss to the recipient). If an 83(b) election is not made, the holder is taxed based on the fair market value of the shares when they vest.
Restricted stock units are awards that represent a promise to transfer shares of a company’s stock in the future if certain vesting criteria are met. The RSUs ordinarily have no purchase or exercise price. After vesting, RSUs are customarily settled in stock but may also be settled in cash. They do not represent actual ownership interests in the underlying shares until vested and settled in stock.
Like restricted stock, RSUs normally are subject to time-based or performance-based vesting and are forfeited if the vesting conditions are not met. Because holders of RSUs are not the actual owners of the underlying shares, they are not entitled to dividend, voting or other stockholder rights until the RSUs vest and the shares are transferred to them. Some companies offer dividend-equivalent rights to holders of RSUs to give them an amount equal to the dividends they would have received if they owned the underlying shares.
Because the grant of RSUs is the grant of a promise and not a grant of property, RSUs are not subject to taxation until the underlying shares vest and are delivered (nor is an IRC Section 83(b) election available upon grant).
If the underlying shares are not transferred to the holder of the RSUs within a short period of time after vesting, the delayed transfer may subject the holder to adverse tax consequences under IRC Section 409A. RSUs can also be complemented with deferred compensation plans that may permit further long-term deferral of taxes owed upon vesting.
An ISO is an option granted by a corporation to an employee to purchase stock of the employer or its parent or subsidiary. ISOs granted pursuant to a tax-qualified stock incentive plan such as your Plan receive special tax treatment under the Internal Revenue Code. If certain tax requirements are met, then there is no taxable income to the employee at the time of grant or timely exercise of an ISO¹. If the stock is held for at least two years from the date of grant and at least one year from the date of exercise, then any gain realized on a subsequent sale of the shares will be taxed as a capital gain. If these holding periods are not satisfied at the time of disposition (a “disqualifying disposition”) where the amount realized is greater than the fair market value of the stock on the date of exercise, then the excess of the fair market value of the stock on the date of exercise over the price paid on exercise is taxed to the employee as ordinary income, while the excess of the amount realized over the fair market value of the stock on the date of exercise is recognized by the employee as capital gain.
In order for an option to qualify as an ISO under the tax law, the plan providing for the grant of ISOs must be approved by stockholders within 12 months before or after it is adopted, must specify the aggregate number of shares of employer stock that are available for issuance under the plan, and must specify the employees or class of employees eligible to participate in the plan. Your Plan satisfies these requirements. Each option must be granted within 10 years of the date that the plan is adopted or approved, and must be exercisable only within 10 years of the date of grant.
The grantee of the ISO must be a full-time employee of either the corporation granting the option, a parent or subsidiary of the granting corporation, or a corporation that has assumed the options pursuant to a reorganization, or a parent or subsidiary thereof. The grantee must remain an employee of the corporation granting the ISO, or a parent or subsidiary thereof, from the time that the ISO is granted until three months before it is exercised (extended to one year in the case of an employee whose termination of employment is caused by disability, and with no time limit in the event of the employee’s death). The terms of the plan may specify shorter exercise periods.
Under IRC Section 409A, the exercise price of the ISO must at least equal the fair market value of the stock at the time the ISO is granted (which results in non-public companies often obtaining 409A valuations prior to issuing ISOs). In the case of an individual who owns stock possessing more than 10% of the total combined voting power or all classes of stock of the employer corporation or of its parent or subsidiary corporation, the option exercise price must be at least 110% of the fair market value of the stock at the time the ISO is granted, and the option period must not exceed five years from the date of grant.
There is a $100,000 limit on the aggregate fair market value (determined at the time the option is granted) of employer stock that can be exercised under an ISO for the first time by an employee during any calendar year. Any options exceeding that limit are treated as NSOs. Finally, an ISO cannot be transferable, except at death, and must be exercisable, during the employee’s lifetime, only by the employee.
NSOs are options that do not satisfy the Code requirements for ISOs and, as such, are not subject to specific tax eligibility conditions and do not qualify for the special tax treatment that is given to ISOs. NSOs differ from ISOs in several important ways. For example, restrictions that apply to ISOs regarding option exercise price, plan and option periods, option transfers, and the number of options that may be granted do not apply to NSOs. In addition, unlike ISOs, both employees and non-employees (such as independent contractors and non-employee directors) may receive NSOs.
In general, there is no taxable income to the grantee of an NSO at the time of grant provided the exercise price is at least equal to the fair market value of the stock at grant (which, again, results in non-public companies being recommended to obtain 409A valuations prior to issuing NSOs). However, the difference between the value of the stock at exercise and the exercise price is ordinary income to the grantee at the time of exercise. If the grantee is an employee or former employee of the company, the income recognized on exercise is subject to income tax withholding and to employment taxes (which includes Social Security, Medicare and other payroll taxes). When the stock is later sold, the gain or loss is capital gain or loss (calculated as the difference between the sales price and tax basis, which is the sum of the exercise price and the income recognized at exercise).
SARs are a contractual right granted to an employee or other service provider of a company that entitle the recipient to receive an amount equal to the appreciation in the value of the underlying company shares from the date the SAR is granted until the date the SAR is exercised. SARs are customarily subject to a vesting period and, once vested, may be exercised at the election of the employee. Like stock options, a recipient’s ability to exercise the SAR is typically subject to the satisfaction of vesting requirements. SARs are most commonly settled in cash, but may also be settled in shares. It is important to establish a fair formulation of valuation in order to avoid the suspicion of the recipients. Available formulas include the book value, the book value adjusted to reflect appreciation or depreciation of assets, multiples of earning standards, standards based on comparable companies, or a blend of these formulas. Finally, because SARs are only a contractual right, the recipient has none of the rights of a stockholder.
SAR plans are flexible because they are not offered in order to receive special tax benefits through such plans. Recipients are taxed at ordinary income rates when the right to the benefit is exercised. SARs that meet the following two requirements are exempt from IRC Section 409A, and are generally taxable to the holder when exercised. First, the exercise price of the SAR must not be less than the fair market value of the underlying stock on the grant date, and second, the SAR must not include any additional deferral features. SARs that do not meet the two requirements above must comply with or meet another exemption from IRC Section 409A or the holder will be subject to adverse tax consequences. Similar to ISOs and NSOs, given these 409A issues, non-public companies are often recommended to obtain 409A valuations prior to granting SARs.
“Phantom stock,” is similar to SARs, with a subtle variation. Phantom stock entitles the recipient to the full value of the shares at the time of vesting, rather than only the appreciation in value from grant to vesting. Additionally, phantom stock generally does not need to be exercised by the employee. Instead it is settled on vesting without the need for exercise.
Phantom stock, like SARs, is a contractual right to granted to an employee or other service provider of a company that entitle the recipient to receive an amount that is linked to employer stock. Phantom stock more commonly vests on a time basis rather than a performance basis, but oftentimes vests on a sale of the company, with the intention to motivate employees to grow the company’s value aimed at a future sale.
Phantom stock is taxable to the holder on vesting, or if payment is deferred, on actual payment. However, if the phantom stock provides for a deferral of the cash or stock payment after vesting, the holder may be subject to adverse tax consequences under IRC Section 409A.
Phantom stock plans may be structured so that the holder of phantom stock receives payment upon the occurrence of different events. For example, a holder of phantom stock may receive dividends alongside actual stockholders as if the holder of phantom stock was a stockholder. Other plans provide for payment only upon a liquidity event, which is most often the sale of the company or the sale of substantially all of its assets.
The company implementation of a long term incentive plan requires a system for administering it and the various issuances to recipients. Some companies hire outside administrators to assist in implementing and operating the plan, and many of the stock brokerage firms have packages for handling the tax compliance and administrative requirements for issuing stock to employees. However, many of our small to middle market clients choose to have a Fortis Law Partners attorney assist them with stock plan administration until they can hire someone to manage their plan.
If you have additional questions, please contact a member of our Corporate team.
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