Royal Financial

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What is stock-based compensation?
Simply put, it’s a method used by businesses to compensate employees for their services. Typically an employer will pay you in cash, however some companies may pay employees in stock for various reasons discussed below. 

Why compensate with stock?
There are advantages and disadvantages to offering stock-based compensation. These (along with tax implications) should be considered when a company is deciding whether to offer stock-based compensation:

How Stock Compensation Works?
It all depends on how the company decides to structure the plan. It is important to consult an adviser regarding the type of plan as it can have implications on how the employer and employee pays taxes. See below for a quick summary of some common stock-compensation plans.

1. 1. Restricted stock awards (RSAs) – Grant of company stock to employees subject to a vesting schedule. The “restriction period” is considered the “vesting period”.
      • Note: There is an 83(b) election available to employees to pick up the income tax on the grant date. Election must be made within 30 days of the grant date.
   2. Restricted stock units (RSUs) – Promise from the employer to deliver stock or cash (less common) to the employee in the future, based on the stock’s performance. The IRS doesn’t treat RSUs and RSAs in a similar manner because in Uncle Sam’s mind, RSUs are not property and as such not governed under the same laws as RSAs.
      • • Note: In practice RSUs are paid out after the vesting date. Employers can take a deduction for RSUs when they are constructively paid to the employee (not when vested). Deduction is for the amount the employee picks up as income. 
        • Withholding: Employers also must withhold applicable income taxes from these payouts, however, unlike RSAs, RSUs are subject to special timing rules for FICA taxes on deferred compensation. If the RSU permits, the employer may defer delivering the payout to the employee until after the vesting date. As a result, employer and employee must pay FICA taxes on vesting date, whether or not RSU was received.
   3. Non-qualified stock options (NQSOs) – NQSOs are options that don’t meet the definition of ISOs. Taxable events generally occur when options are exercised. 
      • • Note: Employer is entitled to a deduction equal to the amount of the ordinary income recognized by the employee on the spread between the FMV of the stock on the exercise date and the option exercise price. Employers are also required to withhold income and FICA taxes at such exercise date. 
   4. Incentive stock options (ISOs) – Only available to employees and not independent contractors, ISOs give the employee the right to buy stock shares at a predetermined price without creating a taxable event. 
      • • Note: ISOs generally don’t cause a taxable event (no deduction by Company and no income pick-up by employee) until employee sells. Once shares are sold they are sold at capital gain rates. However, employees and employers must satisfy various requirements:
          1. Option price must be at least the FMV of the stock on grant date;
          2. Option must be granted pursuant to a written plan that generally must be approved by the shareholders within 12 months before or after the date the plan is adopted;
          3. Grants are only to employees and are generally non transferable;
          4. The option plan term does not exceed 10 years, and the employees must exercise the option within 10 years of the grant date;
          5. The total FMV of the stock options that first become exercisable is limited to $100,000 in any calendar year; AND
          6. The employee must not dispose of the ISO shares sooner than two years after the grant date and one year after the exercise date (see below).
             

If all the above conditions are met, the employer would never get a tax deduction for the ISO stock compensation. However, if any of the above are not met, ISO is treated as NQSO. Further, upon a disqualifying disposition of an ISO (#vi. above) proceeds up to FMV of the shares on the exercise date, less exercise price paid by employee, will be taxable compensation income to the employee (and deductible to employer for same amount ).

Click Employer Tax Consequences for a summary of tax impacts.

In Summary
When deciding whether to use stock-based compensation the employer should consider both the operational advantages and disadvantages  it can have on the company, as well as the tax implications to the employer and employee. 

Disclaimer: The information provided herein is intended solely for informational purposes and no person(s) or other third-party may rely upon it as financial, tax, or legal advice or use it for any other purposes. As a result, Royal Financial, and any affiliates, assume no responsibility whatsoever to readers, or any other persons for that matter, as a result of the information contained herein.