I am frequently asked the following question: Can a service provider receive a warrant in connection with the provision of services?
The short answer is yes, but it is important to keep in mind that a warrant received in connection with the performance of services will be taxed just like a compensatory stock option.
Continue Reading...Historically, the Internal Revenue Code of 1986, as amended (the “Code”) required corporations to provide an annual informational statement to each employee acquiring stock pursuant to the exercise of an incentive stock option (“ISO”) or under an employee stock purchase plan (“ESPP”). Congress changed this rule back in 2006 to also require employers to file an information return with the IRS. (Specifically, the Tax Relief and Health Care Act of 2006 amended Section 6039(a) of the Code.)
Continue Reading...Startups frequently have to answer this question: What type of equity incentives should they grant their employees? For C corporations and S corporations there are generally 4 possibilities:
ISOs are stock options that qualify for the special tax benefits under section 422 of the Internal Revenue Code (no ordinary income tax on exercise—but watch out for AMT (alternative minimum tax)—and capital gain on sale if 2 holding periods are met). Among other restrictions, ISOs (a) can only be granted to employees, pursuant to a shareholder approved plan; (b) must have a term not greater than 10 years (or 5 in certain circumstances); (c) must have an exercise price not less than fair market value as of the grant date (or greater in certain circumstances); and (d) not more than $100,000 in value can vest in any 1 year. By restricted stock, I mean actual stock issuances, subject to repurchase rights at cost (or similar restrictions), which restrictions lapse over a vesting period. And by phantom equity I mean a wide range of contractual arrangements (such as stock appreciation rights) that are not actual shares of stock, but are designed to approximate the rewards of stock ownership.
The type of equity award a company should grant its employees depends in part on the stage of the company. For very early stage companies the tax consequences of restricted stock can be favorable (employee starts capital gains holding period) and bearable (meaning the tax owed upon grant, if there are no repurchase restrictions, or in connection with filing an election under Section 83(b), if there are restrictions, is not too painful). However, once a company's value has gone up, such that issuing inexpensive stock from a tax standpoint is too expensive or too uncomfortable, I usually recommend companies use NQOs for the following reasons:
The table below summarizes some of the key federal income tax consequences of each of these types of awards. It is a high level summary only. If you want more detail, please contact me.
|
Tax Consequences |
NQO Priced at FMV at Grant |
ISO Price at FMV at Grant |
Stock Grant |
|
At Grant |
None (as long as priced at FMV) |
None (as long as priced at FMV) |
Taxable unless subject to vesting restrictions, or even if subject to vesting restrictions, taxable if the recipient elects to be taxed immediately by filing an 83(b) election within 30 days of receipt |
|
At Vesting |
None (as long as priced at FMV) |
None (as long as priced at FMV) |
Taxable if not already taxed; tax based on FMV of shares on vesting (income and employment taxes due at this time for employees) |
|
Upon Exercise |
Taxed as ordinary income (income and employment taxes due at this time) |
No ordinary tax; AMT adjustment (watch out, can be very significant) |
Not applicable |
|
Upon Sale |
Capital gain (short term or long term depending on time passed since exercise) |
Capital gain if holding periods are met (2 years from grant; 1 year from exercise); otherwise, ordinary income) |
Capital gain (short term or long term depending on time passed since the value of the shares was taken into income) |
Early stage companies frequently want to bring on key hires and incentivize them with equity, but do not know what type of equity award is the best from a tax perspective to both the employee and the company. There are in general two types of equity awards most commonly used (assuming that the company is operating in the corporate form and not as a limited liability company):
In general, for a private company with limited cash reserves, and whose key hires also desire to preserve their cash (and not pay it to the IRS), stock options are usually going to be a preferable alternative to stock grants (unless the current value of the stock is so low that the immediate tax impact is nominal).
The reason? Stock grants will be taxable either (1) upon grant, if fully vested, or if a Section 83(b) election is made (in which case the taxes must be paid immediately upon grant, and will have to be withheld from the employee--i.e., the employee will have to write a check to the company for the taxes), or (2) upon vesting, when the value may be considerably higher than the value on the date of grant (and the taxes must then be paid at that time, and the employee will have to write a check to the company at that time for the taxes).
The primary benefit of a stock option as opposed to a stock grant is that if the stock option is priced at fair market value on the date of grant, the receipt of the option is not taxable to the optionee, and the option will not be taxable at all until exercise--the timing of which the optionee controls (as opposed to a vesting date for a restricted stock award).
"Section 409A"--Section 409A of the Internal Revenue Code requires the inclusion in income of deferred compensation paid pursuant to a deferred compensation plan that fails to meet certain requirements, or that is not operated in accordance with certain requirements.
If a deferred compensation plan fails to meet the Code's requirements, or is not operated in accordance with the Code's requirements, then all compensation deferred under the plan for the taxable year and all preceding years must be included in gross income for the tax year to the extent not subject to a substantial risk of forfeiture or not previously included in gross income.
If compensation is required to be included in gross income under Section 409A, the tax imposed by 409A for the tax year is increased by interest and an amount equal to 20% of the compensation which is required to be included in gross income.
Compensatory stock options and compensatory warrants are subject to Section 409A, and under Section 409A all such options must be granted at fair market value on the date of grant. If a compensatory option is granted at below fair market value, the amount that must be included in income is the spread between the fair market value and the exercise price upon vesting, plus 20% of that amount, plus interest.
Non-compensatory warrants, such as those received in connection with making a loan, are not subject to Section 409A, although they raise other tax issues.
It is very common for a company to hire an employee on a specific date and in the employee's offer letter state that "subject to board of directors approval, the employee will be granted a stock option" to acquire a certain number of shares, "with an exercise price equal to the fair market value of the company's stock on the date of grant."
What happens if the stock rises in value between the hire date and the grant date?
The option must be priced at the fair market value on the grant date--meaning, the date the board of directors grants the options, in order to avoid potentially adverse tax consequences to the optionee under Section 409A of the Internal Revenue Code. The hire date is not the relevant date for avoiding potential Section 409A tax problems.
For most private companies the risk of the fair market value of their stock increasing between a hire date and the next board meeting is not too great of a concern, but it can happen. What is recommended? Managing new hire expectations with regard to the timing of the grant. Among other things, include the language above in your offer letters--"subject to board of director's approval, .... with an exercise price equal to the fair market value of the company's common stock on the date of grant."
New companies frequently have to confront this issue. After the founders stock issuances, the founders want to grant stock options to new hires. Internal Revenue Code Section 409A requires that stock options be granted at fair market value to avoid adverse tax consequences.
But how do you determine fair market value?
The law does not require that companies hire an independent, third party appraiser to value your stock. You may want to; it may be very helpful to you if you do. But the law does not require it.
What the law does require is that the valuation be determined by the "reasonable application of a reasonable valuation method."
In general, we recommend at a minimum that companies make a determination of fair market value based on the value of assets and liabilities on the balance sheet, discounted cash flows if projections are possible, and any third party offers to buy the stock of the company (if available), and the company should keep a record for its own purposes of how it reached its conclusons. We are of course lawyers and not valuation experts, and companies may want to consult with valuation consulting firms if they do not feel comfortable with their internal capabilities in this regard.
"Reverse Vesting" is an expression used to describe a situation in which an employee or independent contractor or consultant receives stock subject to repurchase by the company at an at-cost purchase price, which repurchase right lapses over the vesting period. Thus, it is the reverse of the typical situation, where the service provider receives a right to purchase stock (an option) which right is not exercisable until the service providers vests.
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