CHAPTER 16

Equity-Based Compensation

Introduction

There is a mechanism for providing employees (usually executives) with a substantial monetary benefit and also aligning their interests with shareholder interests. Equity-based compensation programs transform employees into shareholders. There are numerous different options to create this transformation. The company could implement one of the several strategies to transfer actual shares to the employees, or they could create an asset that gives them the stockholder incentives without having the requisite voting rights. Each strategy has different pros and cons, and each also has a different taxation. If you are either an executive or a professional who might advise someone who is, then this chapter will provide you with valuable information on equity-based compensation plans.

Learning Goals

• Understand how equity-based compensation can be useful.

• Identify what unique considerations apply to a closely held business that offers an equity-based compensation.

• Understand the differences between nonqualified stock options (NQSOs) and incentive stock options (ISOs).

• Identify the usefulness of employee stock purchase plans (ESPPs).

• Identify how a smaller business might use phantom stock or stock appreciation rights (SAR) to offer a meaningful benefit to their employees.

Overview of an Equity-Based Compensation

Up to this point in the textbook, the retirement planning focus has been on either qualified or nonqualified retirement savings plans. We will now broaden our view to include the equity-based compensation, which could include NQSOs, ISOs, employee stock purchase plans, restricted stock, phantom stock, and SAR.

The common trait among all of these different plan types, which will be thoroughly explained in this chapter, is that they all help to resolve the agency conflict by giving the employees an incentive for the company’s stock to do well. You may recall, from a previous chapter, that the agency conflict is the tension that exists when the firm’s owners are not also the managers. The managers might not make decisions that are in the best interest of the owners. This is the essence of the agency conflict, and the employee stock ownership is one way to help manage this risk for the owners.

An equity-based compensation is very common with startup companies. They are rich in ideas and (hopefully) potential, but poor in cash. They can reward the valuable employees with shares of stock with the unwritten promise that the employee-owners will benefit handsomely when the market realizes the full potential of the company.

This category of compensation can also be used to encourage specific business goals. The award of shares could be contingent upon the executive or even the company meeting a certain performance threshold.

What About Closely Held Business?

As you can imagine, an equity-based compensation receives its value from the value of the underlying company’s stock. But, closely held companies do not have publicly traded stock so, the value is not as simple to measure. Typically, when we think about a closely held business, we think of small companies. This is usually true, but not always so. Consider Mars (the candy company) and Koch Industries (a large private company engaged in many industries) as examples of some very large closely held companies.

The key to applying an equity-based compensation plan to a closely held business is that the company must apply a consistent valuation concept across both time and divisions. They must use the same valuation multiple over various time periods. They also cannot use a different valuation multiple for different divisions of the same closely held business. Companies might apply an industry standard multiple on book value per share or earnings per share or even revenue per share. Different industries have different standards, but revenue per share is a very common choice because it is subject to the least amount of accounting manipulation.

From the perspective of the employee, one might wonder: how the employee will realize value if the shares are not publicly traded? There is typically an internal market for the shares, in which either other owners or the company itself will repurchase the shares issued through an equity-based compensation program.

The existing owners of the closely held business may be concerned about having their ownership interest diluted by the inclusion of new owners. The shares to cover an equity-based compensation will typically come from the Treasury stock, but the inclusion of new owners will lower the percentage of ownership (and therefore, the division of profits) of the existing shareholders.

One nuance that must be monitored is the percentage ownership that an employee is assigned if the company is an S-Corporation. You might be thinking, “Great, what is an S-Corporation?” An S-Corporation is a domestic company with fewer than 100 shareholders that elects to have all corporate profits taxed as income directly by the owners, and not at the corporate level.¹ They are usually smaller businesses. In an S-Corporation, anyone who owns more than 2 percent of the business will have some odd personal taxation issues dealing with the cost of medical insurance and life insurance premiums, which are paid for by the employer. If the employee crosses the 2 percent threshold, then they might lose certain tax-free benefits.

Other Preliminary Concerns

One concern a company that desires to establish an equity-based compensation plan is how formal to make the “plan.” The Board of Directors could establish a formal “plan” with a compensation committee to award an equity-based compensation to the employees. In this scenario, the Board will typically permit awards up to a certain aggregate dollar amount, at which point the board would need to approve more funding if further awards became necessary. The alternative to this approach is for the Board of Directors to approve equity awards on a case-by-case basis. This second option is much more time-consuming for the Board.

Another concern is the method of accounting used to reflect an equity-based compensation on the company’s income statement. In years passed, companies had discretion on when to report an expense for this category. Now, the rules are clear. The company must record an expense based on the options pricing model for any equity-based compensation that is fully vested, but the mechanics of this approach are beyond the scope of this textbook. Publicly traded companies are limited to $1 million dollars of stock awards except when performance-based thresholds are used, in which case, there is no limitation. Any amounts awarded under an equity-based compensation plan must be disclosed on regulatory filings called an annual proxy statement to shareholders.

The mandatory expensing of an equity-based compensation in the current period has made companies a little less willing to use it, although, the tool is still used in many large companies.

Does an equity-based compensation have any effect on the company’s existing shareholders? It may dilute ownership interests if there are a small number of shares outstanding.

Companies also need to be careful about using an equity-based compensation because it may be deemed a public offering, which will require costly Securities and Exchange Commission (SEC) filings and approvals. The potential costly application of public offering rules can be avoided if the company applies the top-hat exemption. If the plan is restricted to only a select group of employees (like the HCEs), then the share awards are considered a private offering and do not require additional regulatory hurdles.

Nonqualified Stock Options

The whole idea behind an equity-based compensation is to encourage the executives to be focused on increasing the stock price through whatever legitimate and legal business means they can come up with.

A NQSO gives an executive the right to purchase shares of their employer at a specified price (called either the exercise price or the strike price) within a certain window of time. An executive will only exercise their option (actually use the option to purchase shares) if the option is in the money, which means that the current market price is higher than their option price. It would be foolish for an executive to exercise an option with a strike price of $50 per share when the stock is trading at $40. They could buy the shares much more cheaply on the open market and just let their option expire worthless.

The strike price on an NQSO must be at least 100 percent of the current market price, which is also called the fair market value (FMV). It is very common for the option to expire after 10 years. This is a huge window of time in which the executive can earn a substantial profit if the stock appreciates in value. Companies can use either a cliff- or a gradedvesting schedule. There is not a mandated vesting requirement like an Employee Retirement Income Security Act (ERISA) plan will have.

Per the constructive receipt doctrine, all equity-based compensations are taxable once the executive is fully vested, unless the company chooses from a series of specific distribution dates. The company can choose to set the distribution date at termination, death, disability, or a specific date that is longer than the vesting time period.

NQSOs have a unique tax treatment. They are taxed at ordinary tax rates when the option is exercised. The ordinary tax rate applies to the difference between the FMV and the strike price. Social security taxes are due at the same time, and the employer will receive a tax deduction equal to the same amount that the executive realizes as a taxable income. Assuming that the executive does not immediately sell their shares after exercising the options, any additional gain (or loss) is treated as a capital gain. If the shares are held longer than one year, then the executive will receive the more favorable long-term capital gains tax rate.

Consider an executive whom we will name Ellen. She receives an NQSO to purchase 500 shares of the employer’s publicly traded stock at the current market price of $25 any time over the next 10 years. After one year, the stock has risen to $65 and Ellen decides to exercise her fully vested options. She holds the shares for an additional 1.5 years and then ultimately sells the shares at $90. What a great deal for Ellen!

How does this look from a tax perspective for Ellen? Starting at the beginning of the transaction, she will pay $12,500 ($25 × 500 shares) to purchase the stock. She now has some skin in the game so, to speak she will receive $20,000 ([$65 - $25] × 500 shares) of the taxable income at option exercise, and her employer will, therefore, receive a $20,000 tax deduction in the year of exercise. Notice that Ellen’s cost basis is now equal to $65 per share ... the amount that Ellen paid ($25 per share) to buy her shares plus the amount of ordinary income ($40 per share [$65 - $25]). When Ellen eventually sells her shares, she will have a $12,500 ([$90 - $65] × 500 shares) long-term capital gain. Had the shares declined below $65 per share, then she would have realized a taxable capital loss instead of a capital gain.

Incentive Stock Options

An ISO is essentially a “qualified” stock option. Investors get certain special tax benefits if the option follows certain rules to remain “qualified.” Like its nonqualified counterpart (the NQSO), an ISO must have a strike price, which is at least 100 percent of the FMV at the time that the option is granted, but an ISO must be approved by the shareholders. The time window of an ISO is limited to 10 years, while an NQSO does not have a strict limit. While an NQSO does not have any specific dollar limit, an ISO is limited to $100,000 annually. This limit is based on the number of shares multiplied by the strike price. There is an additional limitation if the executive is already at least a 10 percent owner. In this case, the strike price must be at least 110 percent of the FMV at the time of the option award, and the time window is also limited to only five years. While an NQSO can be awarded to anyone the Board wishes (consultants, contractors, etc.), an ISO can only be awarded to the employees of the company.

You can see that the ISO has less flexibility than the NQSO. Why would anyone want to use an ISO? The answer is the tax treatment.

At the time that an executive chooses to exercise an ISO contract, there is no tax consequence! However, there may be an issue with alternative minimum taxes (AMT) rules. The nuances of AMT rules are beyond the scope of this textbook, but understand that under certain special circumstances, an executive could still owe AMT taxes when no ordinary income taxes are due.² They should consult with their tax professional before exercising their options.

With an ISO, the real taxes are due when the stock is ultimately sold. If the stock has been held for at least two years from the grant date and at least one year from the exercise date, then all gains are considered long-term capital gains. Table 16.1 shows the various income tax brackets and the associated long-term capital gains tax rates. Notice that the long-term capital gains rates are always lower than ordinary income. If the earnings are all considered capital gains, then the employer will not receive a deduction. They only receive a deduction when the employee has ordinary taxable income. If the two-year or one-year holding requirement is not met, then the ISO will be disqualified and taxed the same way that an NQSO is taxed ... ordinary income on the difference between the strike price and the exercise price and capital gains based on the actual holding period (could be either long term or short term).

Let’s revisit our well-paid executive, Ellen, from earlier in this chapter. She still receives an equity-based compensation, but this time, it is an ISO instead. Her ISO gives her the right to purchase 500 shares of the employer’s publicly traded stock at the current market price of $25 any time over the next 10 years. After one year, the stock has risen to $65 and Ellen decides to exercise her fully vested options. She holds the shares for an additional six months when some favorable news causes the stock to lurch forward. She decides to capture this unexpected market movement now and sells her shares for $90 per share. What a great deal for Ellen!

How does this look from a tax perspective for Ellen now? Starting at the beginning of the transaction, she will pay $12,500 ($25 × 500 shares) to purchase the stock. That is all that is taxable until the stock is sold. Ellen’s cost basis is, therefore, $25 per share (the grant price). Because Ellen does not have taxable income to report, her employer will forego a tax deduction. The problem for Ellen is that she violates the ISO holding period requirement ... the two-year or one-year rule. By selling six months after the exercise date, she has effectively disqualified her ISO and now everything is tax as a short-term capital gain (less than one year holding period), which is the same thing as ordinary rates. Following this example, there was no benefit to Ellen to have an ISO, rather than an NQSO.

Table 16.1 Capital gains tax rates

What if instead of selling at $90 per share after six months, it took 1.5 years to reach that price, and therefore, the eventual sale of the shares? In this case, Ellen has not violated the two-year or one-year holding period requirement, and there certainly is a benefit for her to have an ISO, rather than an NQSO. Now, starting at the beginning of the transaction, she will pay $12,500 ($25 × 500 shares) to purchase the stock. That is all that is taxable until the stock is sold. Ellen’s cost basis is, therefore, $25 per share (the grant price). Because Ellen does not have taxable income to report, her employer will still forego a tax deduction. But now, the gain of $32,500 ([$90 - $25] × 500 shares) is all taxed as a long-term capital gain, which is a considerable advantage over ordinary tax rates. Patience pays ... if you can wait.

Another very important distinction between an ISO and a NQSO is gifting. An ISO must be nontransferable, which means that only the executive who received the grant can exercise it. On the other hand, an NQSO can be gifted, subject to gift tax rules. This means that the executive could give their NQSO to a child or grandchild to help with a financial need. Gifting an NQSO will remove an asset from the participant’s broader estate and target to money toward one specific beneficiary. See Table 16.2, for a comparison of ISOs and NQSOs.

Table 16.2 Comparison of ISOs and NQSOs

Employee Stock Purchase Plans

An employee stock purchase plan (ESPP) is nothing more than a discount stock purchasing program for the employees, and it is only available for the employees. An ESPP must be approved by shareholders before it is implemented. This benefit is only available to full-time employees of the company (no subcontractors) who have at least two years of completed service, but anyone who already owns 5 percent of the company cannot participate in an ESPP. The plan is limited to $25,000 in actual purchases for any given year.

One special feature of an ESPP is that this plan must have broad participation. This means that the employer cannot offer the plan to only the HCE population ... every employee must be included who has at least two years of full-time service to the company. Every employee except those who own more than 5 percent of the company. The idea is that the executives might be offered stock options, while the rank-and-file employees could be offered an ESPP to provide incentives for the employees of all income ranges.

ESPPs have what is called an offering period, which is simply the window of time in which the employee can purchase shares at the stated percentage discount. The percentage discount could be based on the price at the beginning of the offering period or at the end of the offering period. It is not a situation where the employee gets to pick any day in between. Some companies will apply the look back rule, which states that the employees can retroactively choose whether they want the price at the beginning of the offering period or the ending price. If this extra benefit is applied, then the offering period is limited to 27 months.

Functionally, an employee who chooses to participate in an ESPP will have money withheld from their net pay (after-tax) to purchase shares of the employees a tremendous incentive to purchase shares and, therefore, have a vested interest in how the company performs.

If an employee holds the stock for at least two years from the beginning of the offering period and at least one year after the shares are purchased, then the employee will receive special tax treatment. The dollar discount received will be taxed as ordinary income, while any subsequent growth (or loss) in value is a capital gains issue.

Consider an employee whose employer has a publicly traded stock currently priced at $10 per share. If the company offers a 15 percent discount, then the employer will withhold money from the employee’s after-tax paycheck and use the money to purchase shares at $8.50. This is all after-tax so, there are no complex tax rules to understand. The employee simply will have a capital gain (or loss) whenever they should choose to sell. If this employee, who purchased shares at $8.50, sold their shares immediately, then they would realize a 17.6 percent ([$10 - $8.5]/$8.5) instant return! Note that a 15 percent discount will produce an immediate benefit greater than 15 percent. In this case, the investor would pay taxes at the higher short-term capital gains rate, but at least they locked in a profit.

Special Equity-Based Plan Types

Another way to structure the employee stock ownership without forcing the employees to pay out-of-pocket is called phantom stock. Phantom stock is nothing more than a unit of ownership that is tied to the movement of the company’s actual stock. The phantom stock units will have a fixed term (maturity period). Employees will receive a payout based on the appreciation in the units, which is actually the appreciation in the underlying stock. The employer establishes, in advance, when the phantom stock is redeemed.

One neat feature is that the employee accounts can be credited with dividends based on any dividends paid to the actual underlying company stock. The value of any phantom stock received is considered ordinary income for the employee and, therefore, a tax deduction for the employer. The company should be clear on any additional payment triggers, such as retirement, death, or disability.

Consider an employer who grants an executive 10,000 shares of phantom stock when the company’s stock is trading at $50. The phantom stock matures in five years and at that time, the company’s stock has grown to $75. The executive will receive a check for $250,000 ([$75 - $50] × 10,000 shares), which is all ordinary income and, therefore, tax deductible for the employer and fully taxable to the employee.

Can you image a birthday where you are given a brand new iPhone with the understanding that, if you fail to meet a specific behavior target, then you will lose the iPhone? That is essentially how restricted stock works. Restricted stock is a gift of shares from the employer to an employee, but the gift contains a caveat that all shares are forfeited if the employee leaves the company within a certain window of time. This is a great way to retain key talent!

While the restricted shares are owned by an employee, they will collect any dividends paid to those shares. This form of an equity-based compensation is a great way to encourage employment loyalty and to marry the employee to the performance of the company. From the employee’s perspective, this method of compensation is more secure than a traditional nonqualified deferred compensation plan because the stock is registered in the employee’s name and is, therefore, not subject to the creditors of the employer.

Once the substantial risk of forfeiture has been removed, the shares will become taxable to the employee. At this point in time, the value in the company’s stock is treated as ordinary income and the employer will therefore receive a tax deduction.

There is one special tax advantage available to the recipients of restricted stock. This is known as the §83(b) election. An employee with restricted stock can use the §83(b) election to be taxed on the value of the stock at the grant date. They have 30 days from the grant date to make this election. Using §83(b) means that the grant date price is taxed and with an appreciating stock, this could be a significant savings. Even greater saving is possible because the grant price now becomes the cost basis and any addition appreciation (or depreciation) will be taxed as a capital gain. The holding period begins on the grant date, which means that as long as the period of restriction is at least one year and one day, then any gain beyond the grant price is taxed at the very favorable long-term capital gains tax rates. However, this is very risky for the employee. If they make the §83(b) election to be taxed at the grant date, there is no tax refund available if the stock loses value or the employee’s shares are never held past the restriction period. Yes, they could claim a capital loss if they hold the shares past the restriction period and sell below the grant price, but they will not be refunded the §83(b) taxes paid at granting.

SAR are very similar to a phantom stock. They are an ownership interest not in the employer’s stock directly, but in the appreciation potential over a certain period of time. Just like with the phantom stock counter-part, any gains from a SAR are taxed as ordinary income. A key difference is that SARs can be exercised at any point during the offering period!

Consider an employee who has a SAR for 1,000 shares of their employer’s stock with a strike price of $100 per share. Because the employee has a short-term financial need, they watch the stock closely and notice it jump upward to $110. They decide to exercise 100 shares of their SAR. They will receive a check for $1,000 ([$110 - $100] × 100 shares) and be taxed on that amount. The employer will receive a tax deduction for the $1,000 of ordinary income recognized by the employee. Because they do not need any more short-term money, they let the other SARs ride. Just before the remaining 900 shares in the SAR will expire, the employer’s stock has risen to $200 per share. The employee will exercise the remaining 900 shares and realize $90,000 ([$200 - $100] × 900 shares) of taxable income. The employer will also receive a tax deduction for $90,000.

Discussion Questions

1. Identify two reasons why an equity-based compensation might be used in practice today.

2. How could an equity-based compensation be used to mitigate the agency conflict?

3. What are some of the key considerations for a closely held company that wants to offer an equity-based compensation?

4. What is one reason why some companies have become less willing to use an equity-based compensation in the recent years?

5. Why would current shareholders not like an equity-based compensation?

6. How does a new offering of an equity-based compensation avoid the costly process of filing as a new public offering with the SEC?

7. What is the mandatory vesting requirement for NQSOs?

8. What are the tax consequences of NQSOs?

9. Describe the limitations inherent with an ISO plan. Why would an executive be willing to accept these limitations?

10. What are the differences in coverage eligibility between a NQSO and an ISO?

11. An impatient executive who has been granted an ISO waits one year from the grant date to exercise and subsequently sell their options. What is the tax implication of this transaction?

12. A different executive has been granted an ISO; they wait two years from the grant date to exercise their options and an additional two years before selling their shares. What is the tax implication of their timing choices?

13. Describe the limitations and tax consequences of an ESPP if the participant has satisfied the two-year or one-year threshold.

14. Why is phantom stock attractive to a small business?

15. How is phantom stock taxed?

16. Why is a §83 election a risky bet for an employee with restricted stock?

17. What is the difference between phantom stock and SAR?