January 1, 2010
Equity (a Company’s stock if it is a corporation or membership interests if the company is a limited liability Company) may be a Company’s best method to reward long time performance and retain employees. At the heart of a Company’s program is the “Equity Incentive Plan”. This article discusses the types of Equity Incentives common to many Equity Incentive Plans (the “Plan”).
B. General Plan Description
Most Plans are established for certain key employees of the Company, certain consultants and advisors to the Company, and certain non-employee directors of the Company. The Plan document describes the term of the Plan (typically 10 years), as well as how the Plan is administered (typically by the Board and typically the Plan gives the Board wide latitude to make decisions). Most Plans permit the grant of Incentive Stock Options, Non-Qualified Stock Options, Restricted Stock Awards, and other stock grants.
C. Incentive Stock Options versus Non-Qualified Stock Options.
It is important to understand the differences between Incentive Stock Options and Non-Qualified Stock Options. The principal differences between the two types of options are eligibility and tax benefits. With respect to eligibility, Incentive Stock Options are limited to the Company’s W-2 employees. Independent contractor consultants and others that are not W-2 employees are ineligible for Incentive Stock Options. Non-Qualified Stock Options can be offered to both W-2 employees and other individuals or consultants that do not otherwise qualify as a W-2 employee. In both cases, the holder of the option pays a pre-determined amount of money to purchase common stock of the Company – with the expectation that the payment is less than the market value at the time the option is exercised. The tax differences are summarized in the table, below. When the Company grants an Incentive Stock Option or Non-Qualified Option it will need to: (a) take a Board Action; (b) enter into a Stock Option Agreement; (c) enter into a Stock Purchase Agreement; and (d) provide a sample
Notice of Stock Option Grant.
D. Restricted Stock
The other type of equity incentive common under Plans is Restricted Stock. Unlike an option, stock is issued all at once – but subject to forfeiture if the recipient ceases to be employed by the company for a certain amount time. Unlike options, the recipient usually pays nothing for the stock. The tax issues related to Restricted Stock are summarized, below. When the Company grants a Restricted Stock Award (discussed below) it will need to: (a) take a Board Action; (b) enter into a Restricted Stock Agreement and (c) provide a Notice of Restricted Stock Grant. In many instances the recipient will want to make a Internal Revenue Code Section 83 election. This election typically reduces the amount of tax the recipient would otherwise pay if he or she failed to make the election and instead was taxed when the Restricted Stock vests. There is a 30 day time limit in which to make the election, the stock will need to be valued and the valuation is reported by the Company and the recipient, thus, the values need to be the same.
E. Other Grants
Many Plans permit “Other Grants” of common stock. For example, a Plan might provide: “From time to time during the duration of this Plan, the Board may, in its sole discretion, adopt one or more incentive compensation arrangements for participants pursuant to which the participants may acquire shares, whether by purchase, outright grant, or otherwise.” Generally, this contemplates some sort of “Stock Bonus” – usually upon achieving a significant goal or sometimes in lieu of cash bonuses at the end of the year if the Company is cash-poor. A grant covered under this provision would require a Board action and a Stock Purchase or Shareholder Agreement.
F. Summary of Taxation Issues
The chart below summarizes important tax differences between Incentive Stock Options, Non-Qualified Stock Options, Restricted Stock and a Stock Bonus:
Types of compensation and tax consequences