Employees may be rewarded or incentivized through equity compensation as a way to (i) attract and retain employees and (ii) align the financial interests of employees with the shareholders of the company. If a business owner decides to offer employees equity compensation, the owner has a variety of options of how to award equity. Some common options are: a stock option, an Employee Stock Purchase Plan (“ESPP”), an Employee Stock Option Plan (“ESOP”), and a phantom stock plan. Each plan has its own pros and cons and each company should weigh the options, keeping in mind the company’s unique circumstances and employees.
Stock options offer a wide range of flexibility to the business. Stock options can be offered to key employees, executives, consultants or directors, but do not have to be granted to all employees. Stock options give the recipient an option to purchase the stock of a company at an agreed upon price within a certain time period. The two major types of stock options are (1) Incentive Stock Options (“ISOs”) and (2) Non-Qualified Stock Options (“NQSO”).
Incentive Stock Option
An ISO can only be granted to an employee and has specific requirements set out by the IRS. An ISO has an added benefit of favorable tax treatment for the employee because the employee can defer tax on the stock option until the stock is sold. Nonetheless, the company cannot deduct this option as a business expense.
Non-Qualified Stock Option
A NQSO may be granted to employees, contractors or directors. NQSOs do not have specific requirements with the IRS to be established. However, if NQSOs are granted with an option price that is less than the fair market value of the stock at the time of the grant, the company must withhold applicable income and employment taxes of the recipient at the time of option vesting. Additionally, the employee may be subject to IRC §409 which could result in further adverse tax consequences to the option recipient. The company, on the other hand, receives a tax deduction when the recipient exercises the option.
Employee Stock Purchase Plan
ESPPs involve an employee contributing to an ESPP through payroll deductions. These deductions accumulate throughout an offering period which ranges from 3 to 27 months. Generally, at the end of the offering period, the employee may purchase the company’s stock or securities at a discount of up to fifteen percent (15%) of the fair market value. ESPPs are relatively inexpensive and simple for the company to administer. The IRS imposed specific requirements to establish an ESPP, including a non-discrimination requirement meaning all option recipients have the same rights and privileges. The employee may receive some favorable tax treatment if certain requirements are met including holding the stock for at least 2 years from the offering date and at least 1 year from the purchase date.
Employee Stock Option Plan
An ESOP is a form of a retirement plan that is designed to invest primarily in the company’s securities. The plan operates by holding the company’s stock in a trust for employees meeting minimum service requirements and allocated to employees based on relative pay or a formula determined by the company. If the employee is vested in the ESOP, the employee may receive a distribution from the plan after the employee leaves the company or is terminated. Because ESOPs are subject to the Employment Retirement Income Security Act (“ERISA”), the plans must be established on a non-discretionary basis. Essentially, this means the company cannot discriminate between employees participating in the plan or the allocations made to the employees. Additionally, ESOPs provide a tax benefit to the company through tax-deductible expenses for contributions to the plan. Generally, ESOPs are more expensive to establish and maintain because ESOPs require paying fees to a third party administrator to oversee the plan and act as trustee.
Phantom Stock Plan
A phantom stock plan is a way to reward employees without actually giving the employee any actual equity in the company. Rather, the employee receives "phantom" stock. Although the company issues no physical stock certificate, phantom stock pays out with the same price movement of the company’s real stock. In other words, phantom stock is an employee bonus plan that pays out upon certain triggering events. Plans typically either pay out (i) the stock appreciation value over a specific period of time or (ii) the full value of the stock issued, instead of just the increased value. Any bonus money paid out through the phantom stock plan is taxed to the employee as ordinary income and the company qualifies for a tax deduction.
What’s right for your business?
The plan that is right for your business will be determined based on several factors including how many employees you have, which employees you wish to reward, tax considerations, and other circumstances surrounding your company. Businesses are not cookie cutter and your plan shouldn’t be either. For more information or to discuss which plan may be right for you, contact Sheila Seck at 913-815-8485 or firstname.lastname@example.org.