Incentives for Key Employees

Key employees are often asked by newly formed companies to work for less salary than they can command in the marketplace. They do so in order to participate in the upside potential of the company. The form of that participation may vary depending on the circumstances of the employee and the company, and can include incentive stock options, non-qualified stock options, phantom stock and grants of restricted stock. At Sunstein, we recognize the importance of motivating key employees, and have extensive experience drafting and interpreting agreements between employers and key employees.

Incentive Stock Options

Incentive Stock Options are options to purchase the stock of the employer pursuant to arrangements meeting the requirements of section 422 of the Internal Revenue Code. Incentive options are the most common form of equity sharing. They have the advantage of tax simplicity. The key employee pays no tax as a result of receiving the option until he or she exercises it and sells the stock acquired through that exercise. The price to be paid for this simplicity comes in two forms: First, the option must have an exercise price not less than the fair market value of the stock at the time of the grant. The option is thus “out of the money” when it is granted. Second, the appreciation in the underlying stock that occurs between the time that the option is granted and when it is exercised is eventually taxed when the employee sells the stock. If the employee holds the stock for at least one year after he exercises the option, and for at least two years after the option was granted, any gain that results from the sale of stock will be taxed as capital gain. If the employee disposes of the stock during either of these periods, however, the sale is a “disqualifying disposition”, and the difference between the option price and the fair market value of the shares when the option is exercised (the “spread”) will be taxed at ordinary income tax rates.

Although exercising an incentive stock option will usually not result in tax for the rank-and-file employee, the exercise does have an impact on an employee’s alternative minimum tax (“AMT”).Ê During the year of exercise, the spread will be treated as a preference item, meaning that it will be added back to the employee’s taxable income for purposes of calculating his AMT for the year, regardless of whether the employee sells the stock. To the extent the employee does pay an AMT that is higher than what would have been paid under normal tax rules that year, the excess amount becomes a “minimum tax credit” that can be applied in future years when normal taxes exceed the employee’s AMT again. This credit is intended to prevent the AMT from causing a double tax.

Non-Qualified Stock Option

Non-Qualified Stock Options can avoid the problems inherent in incentive stock options, but at the cost of greater tax complexity. The holder of a Non-Qualified Stock option incurs taxable income when he or she exercises the option. If the exercise is followed quickly by a sale of the stock, the problem is minimized. If the option must be exercised (lest it expire) before there is a market for the stock, the option holder faces a cash squeeze. For that reason, executives frequently seek non-qualified stock options with a long term. Companies, however, typically want to avoid having too many options outstanding in order to avoid cluttering up their capital structures, and wish to issue options with shorter terms in order to reduce the impact on the company’s income statement.

Phantom Stock

Phantom Stock can be offered where the founders do not want to dilute their equity ownership, but want to provide key employees with incentives tied to bottom-line performance. Phantom Stock does not involve the issuance of actual stock, but is rather a system of paying bonuses based upon increases in the company’s value. This value can be established in the Phantom Stock Plan at the book value of the company, some multiple of earnings, or a combination of the two.

Restricted Stock

Grants of Restricted Stock can be particularly effective if there is a public market for the company’s shares. Restricted stock is a term of art that includes stock acquired from a company in a private transaction rather than a public offering. The SEC has reduced the period of time that a holder of restricted stock must hold the stock before being able to resell it without potential liability under the Securities Act of 1933. In the case of stock in public companies, that holding period is now one year. For privately-held companies, it is two years. These periods do not apply to sales by persons who are deemed to be part of the “control” group of the company.

Grants of restricted stock have the same potential tax problem that non-qualified options have: A tax liability may arise before the key executive can sell any of the shares. There are tax planning measures available to address this problem in some circumstances. They may involve subjecting the stock to restrictions on transfer and a risk of forfeiture so as to defer the deemed receipt of income, or having the company pay a cash bonus to the employee to help pay the tax bill. The appropriateness of these techniques will vary depending on the circumstances of the employee and the company.

Equity Interests in Partnerships and Limited Liability Companies

Although the Internal Revenue Code authorizes corporations to issue incentive stock options, partnerships and limited liability companies (LLCs) are not granted this ability by statute.ÊIt is possible to craft equity incentive plans for LLCs that mimic the effects of incentive stock options, but such plans involve both tax and operational complexities that can be burdensome. Furthermore, the tax treatment of these plans is somewhat unclear, resulting in tax risk to both the participant and the employer.

Sunstein has experience in the devising plans for each of these types of incentive compensation, and can help you decide which form is most appropriate for your company and management team. Please contact our Business Practice Group for more information about these plans.