Considerations in Granting Stock or Options
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Should I Grant Stock or Options?
Companies, particularly startup companies, use stock and stock options to incentivize company employees. This is particularly useful as startups that cannot otherwise afford to adequately compensate employees. This can be a huge advantage to employees as well. It generally means less liquid compensation up front, but it entails the possibility of long-term gain. It also signals that the company is invested in you as a long-term employee.
Below, we explore the various aspects of stock and options and compare those attributes.
What are Stock Grants and Options?
Stock grants are usually common shares of the company with special restrictions. The major restriction is that the shares may be subject to vesting. This means that the employee is the record owners of the shares, but the employee cannot sell the shares until the restrictions expire or are removed. Vesting generally happens over time (generally 2-4 years) or upon the accomplishment of company milestones. The share might also vest upon the occurrence of specific events, such as a subsequent round of equity funding, company sale, or the company’s initial or direct public offering. If the employee leaves the company prior to vesting, she will generally forfeit ownership of the vested shares. There may be special protections that avoid forfeiture if the employee is fired without justification or cause.
There are many forms of stock option. A common form of employee stock option allows the employee to purchase stock at a specific price. This is known as a “call option”. The employee can force the company to sell her stock at a given price. The option is generally not of value at the time of award. It becomes valuable when the value of the stock rises above the option price. Options are often made subject to vesting in the same manner as stock grants.
There are two types of stock option used to compensate employees and non-employees. Employees generally receive Incentive Stock Options (ISOs). Non-employees, such as independent contractors, consultants, and directors, receive Non-qualified Stock Options (NSOs) — though employees can also receive NSOs. The primary difference is the tax benefits if each, which is discussed below.
Comparing Stock Grants and Options?
Bother stock grants and options afford an employee significant benefits. The more the shares rise in value, the more the employee stands to gain. Both forms also demonstrate a company’s commitment to the employee and vice versa. Both forms of compensation also provide numerous tax benefits. An employee may be able to defer taxes are treat any gain in the value of the stock or options as gain rather than normal income. Stock and options grants also offer tax benefits for company, which can take a deduction without having to shell out cash.
Stock grants has some risk to the employee, as the employee is subject to tax on the value of the stock award, even if the tock later loses value. The stock can also be far less liquid for the holder due to the vesting provisions. Options, however, can be a bit more risky than stock grants because of stock value fluctuations. If a company declines in value, the employee may end up receiving no value at all from the option grant.
Tax Considerations for Stock Grants and Options?
The tax effect is a major consideration for grants of stock or options to employees. If an employee receives a stock grant, she is taxed on the value of the stock at the time the stock ownership vests in her. The value is taxed as ordinary income (rather than capital gains — which generally have a lower tax rate). She also has the options of recognizing the stock grant immediately upon receipt (prior to vesting) by making an election to do so under Section 83(b) of the Internal Revenue Code.
A grant of stock options is treated differently depending upon whether the option is an ISO or NSO. In both instances, the employee does not actually receive any value at the time of the option grant. She simply receives the right to purchase the stock at a given price. In order to receive the tax benefits, the purchase price generally matches the fair market value of the stock at the time of grant. When the employee later exercises the stock option is when she may be subject to taxation. The rise in the value of the stock above the exercise price at the time of grant creates either a capital gain or regular income for the employee. So, when the employee exercises the option, the gain in value will be taxed at the capital gain rate for ISOs or regular income rates for NSOs. Taxation at capital gain rates can be a major advantage for an ISO over an NSO. To receive this beneficial tax treatment (long-term capital gain treatment), the employee exercising the ISO must hold the acquired stock more than one year after the exercise date and more than two years from the date the option grant. Failure to meet these requirements will cause the ISO to be treated like an NSO.
When stock is granted or an option exercised, the employee may decide to continue to hold the stock. If so, the employee will have a “basis” in the stock. The basis is the amount paid for the stock (if exercising an option) or the value of the stock taxed when granted (in a stock grant). The basis will be used to calculate any gain in value when the stock is later sold or otherwise transferred. The difference between the basis and the value at time of sale or transfer is the amount subject to capital gain taxation. Capital gains taxation equals the normal income rate if the stock is held less than 12 months. If held more than 12 months, the capital gains rate is generally between 15 and 20%. If the stock happens to decrease in value from the time of grant or the time of exercise of an option, the employee who sells the stock for the decreased value can use the losses. Capital losses can offset any capital gains from the sale of other assets. If the capital losses exceed the capital gains, an employee who is married filing a joint tax return with her spouse can deduct up to $3000 of capital losses against regular income. Any more losses on the sale can be carried forward to offset capital gains or income in future years.