Attracting and retaining talent is critical to the success of your business. But in a competitive marketplace, it’s easier said than done. You can promote your team-driven culture, your flexible work schedule, and your wide-ranging benefits, but there’s no getting around it: money talks. Providing equity compensation is one way you can make sure your offer package comes through loud and clear.
Since there are several types of equity compensation you could offer, I’ve decided to break this topic up over a series of blog posts. First up: employee stock option plans. Not to be confused with employee stock ownership plans (ESOPs), employee stock option plans involve granting your employees the right to purchase your company’s stock at a fixed price for a stated period of time. (An ESOP involves giving stock to employees.)
There are two main types of stock option plans: non-qualified stock options and incentive stock options. Before you decide which type to implement at your company, it’s important to consider the tax characteristics, statutory requirements, and employee impacts associated with both. Here’s a quick look at each.
Non-Qualified Stock Options (NQSO)
NQSOs can be offered without restriction, and they can also be offered to vendors, contractors, and board of director members—not just employees. Other benefits of NQSOs include:
- No limitation for the option duration, holding period, or aggregate amount to first become exercisable (i.e., eligible for the employee to buy) in any calendar year
- No statutory guidelines for the plan
- Provides a company with greater flexibility in structuring the plan
Expenses recorded on your company’s financial statements for NQSOs are non-deductible for tax purposes. However, you’re allowed to take a tax deduction in the year the option is exercised. In the year of exercise, you would be entitled to a deduction equal to the spread between the fair market value and exercise price of the option. This amount is reported as income on the employee’s Form W-2 or on a non-employee’s Form 1099.
If your company is required to track the balance of deferred tax assets and liabilities under ASC 740, it’s important to keep records of the amounts that have been historically expensed on your financial statements for each NQSO. These amounts will be included in your deferred tax assets and will reverse upon exercise or forfeiture. The truth is, it’s good practice to keep these records regardless of ASC 740 reporting.
Incentive Stock Options (ISO)
ISOs are similar to NQSOs except for their tax treatment and statutory requirements. Benefits of these plans include:
- Enhanced employee incentives
- No tax withholding requirements
Unlike NQSOs, ISOs can be offered only to employees of your company. To be eligible, an employee must be employed at all times during the period beginning on the date the option is granted and ending three months before the date the option is exercised. Other requirements for ISO plans include:
- Plans must be granted under a shareholder-approved written plan
- The options must be exercised within 10 years
- Maximum grant of $100,000 per person
- Options are non-transferable, except at death
- Minimum holding period of two years from the grant date and one year from the date of exercise
- Options must be exercised during employment or within three months after separation
Similar to NQSOs, the expenses recorded on your financial statements for ISOs are non-deductible. In contrast, you are not permitted take a tax deduction when ISOs are exercised. Moreover, ISOs are not reported as income on an employee’s Form W-2.
However, your company would be entitled to a tax deduction in the event of a “disqualifying disposition” by an employee of their ISO. A disqualifying disposition arises if an employee does not fulfill the minimum holding period requirement or exercises the options three months or more after they left your company. If there is a disqualifying disposition, you would be entitled to a deduction equal to the difference between the fair market value at exercise and the exercise price. This amount would be reported to the employee’s Form W-2.
Which stock option plan is right for your business?
Companies typically favor NQSO plans due to the flexibility of having no statutory requirements to comply with, as well as for the tax deduction they receive upon exercises. ISO plans have statutory requirements and do not allow a tax deduction upon exercise unless a disqualifying disposition occurs.
But here’s an important consideration: ISO plans tend to be more favorable to employees since they don’t count as ordinary W-2 income, and employees will recognize capital gains only when they sell their options.
At the end of the day, the plan you choose should be the one that makes the most sense for your company. As I’ll discuss in my next blog post, there are other forms of equity compensation to consider, too. In the meantime, if you have questions about this topic, please don’t hesitate to contact the PWB team.
Contact your PWB advisor today.