Rowbotham & Company Memorandum

Transcription

1 Rowbotham & Company Memorandum To: Executive, XYZ Software RE: Stock Incentives From: Rowbotham & Company LLP Date: November 15, 1999 This memorandum compares the federal tax treatment of four types of incentives generally utilized by corporations in employee compensation plans: stock awards, nonqualified stock options, incentive stock options, and phantom stock. I. STOCK AWARDS In the case of a stock award, the corporation grants the employee the right to receive vested rights to the stock if certain conditions are met in the future. For instance, an employment contract might give an employee a vested right in a certain number of shares at the end of each year that the employee has worked for the corporation. The employment contract might also make it a condition of vesting that the corporation s profits or stock price exceed a target rate of growth each year. When an employee receives a stock award, the employee is taxed at ordinary income rates on the value of the stock as soon as the employee s rights in the stock become vested. At that time, the corporation receives a corresponding tax deduction (for compensation paid). Once the employee is taxed on the value of the stock at ordinary income rates, future appreciation of the stock would not be taxed until the employee disposes of the stock. At that time, the appreciation would be taxed at capital gains rates rather than at ordinary income tax rates. The highest federal tax rate on ordinary income is 39.6% and the highest federal tax rate on capital gains (for stock held a year or more) is 20%. The employee would pay tax on the stock s appreciation at capital gains rates only when the employee disposes of the stock. Exploiting the difference between capital gains tax rates and ordinary income tax rates provides an opportunity for significant tax savings if the corporation s stock appreciates. The reason that an employee is not taxed on the value of a stock award until it vests is that it would be unfair to tax the employee on compensation that the employee has no dominion or control over and that he might never receive. However, an employee may choose to be taxed on the value of the stock award before it vests by making an election pursuant to 83(b) of the Internal Revenue Code at the time of grant. Making an 83(b) election causes the stock to be treated for tax purposes as though it has vested even though it has not yet vested. Tax savings can result from making an 83(b) election before the stock appreciates because the appreciation will not be taxed at the higher ordinary income tax rates. 1

2 The tax treatment of a stock award can be summarized by looking at the tax consequences at four points in time: At the time of grant, there are no tax consequences to the employee or the employer unless an 83(b) election is made to treat the shares as though they were vested; in which case the tax consequences are the same as those at the time of vesting. There is no time of exercise for stock awards. The time of exercise is significant only for stock options which are discussed below. C. The Time of Vesting At the time of vesting, the employee is taxed on the fair market value of the stock at ordinary income tax rates and the corporation receives a corresponding deduction. If an 83(b) election was made at the time of grant, there are no tax consequences at the time of vesting. At the time the employee disposes of the stock, the employee must pay capital gains tax (assuming such stock is held for over 12 months) on the excess of the sale price over the amount previously taxed at ordinary income rates. There are no tax consequences to the corporation. II. NONQUALIFIED STOCK OPTIONS An option entitles the employee to buy stock in the corporation in the future at a fixed price Nonqualified stock options do not qualify for special treatment under the Internal Revenue Code. Nonqualified stock options are taxed under the same rules that apply to stock awards. However, the rules are applied differently because options that are not publicly traded are usually not considered property for tax purposes until they are exercised. Options are merely considered a right to obtain property in the future. An option must be exercised before the employee is taxed. The mere grant of a stock option in a private company is not a taxable event even if the employee s right to exercise the option is fully vested. Thus, if the employee s right to the stock by exercise is not vested, the employee must wait until the time the options are exercised to make an 83(b) election. Once the option is exercised the employee is in a situation similar to the one in which the employee has received a stock award. However, because the employee must pay the option 2

3 exercise price to obtain the stock, the employee is taxed at ordinary income tax rates on the fair market value of the stock less the option exercise price. If the employee makes an 83(b) election or the employee s rights are vested at the time the option is exercised the fair market value is determined at that time, otherwise the value is determined at the time of vesting. As with a stock award, it may be desirable for an employee to pay tax at ordinary income tax rates before the stock substantially appreciates, since this appreciation would be taxed at lower capital gains rates assuming the stock is held for the requisite period. Thus, it may be advantageous to exercise an option and make an 83(b) election before the time of vesting in order to avoid paying tax at ordinary income tax rates on the stock s appreciation. The tax treatment of nonqualified stock options can be summarized by looking at the tax consequences at four points in time: At the time of grant of an option, there are no tax consequences for options which are not publicly traded because they are not considered property for tax purposes. The time of exercise may occur either before or after the time of vesting. If it occurs before, there are no tax consequences unless an 83(b) election is made to treat the shares as though they were vested. If exercise occurs after vesting, the employee is taxed on the value of the shares less the option exercise price at ordinary income tax rates. The corporation takes a corresponding deduction. C. The Time of Vesting At the time of vesting, the employee is taxed on the fair market value of the shares at ordinary income tax rates if the option has already been exercised and if the employee has not already been taxed on their value due to an 83(b) election at the time of exercise. At the time the employee disposes of the stock, the employee must pay capital gains tax (assuming the stock is held for greater than 12 months) on the sale price of the stock less the option price paid and the amount previously taxed at ordinary income tax rates. There are no tax consequences to the corporation. 3

4 III. INCENTIVE STOCK OPTIONS Incentive stock options ( ISO ) are stock options that qualify for special tax treatment (under 422 of the Internal Revenue Code) by satisfying certain statutory requirements. ISOs are taxed like nonqualified stock options except that when they are exercised and vested, there is no ordinary income tax liability for the employee. However, income for determining alternative minimum tax (AMT) is increased by the value of the stock less the option price. AMT is paid by some taxpayers instead of ordinary income tax if their ordinary income tax is reduced too much by tax breaks. AMT applies in many situations where ISOs with substantial value are exercised. The spread while not being subject to ordinary tax creates a substantial tax preference subject to AMT. AMT is computed by adding back the value of certain tax breaks (called preferences) to ordinary taxable income and then calculating tax at a lower tax rate than at ordinary income tax rates. A taxpayer pays the higher of ordinary income tax or alternative minimum tax. Thus, an ISO only increases the tax that would be subject to AMT. There is currently no provision in the Internal Revenue Code or Treasury Regulations concerning whether or not an 83(b) election may be made with respect to incentive stock options. Thus, it is uncertain whether the IRS would permit an employee to make an 83(b) election. If the 83(b) election were not allowed, the employee would not be allowed to pay alternative minimum tax until the stock is vested. If the stock does not vest until after it appreciates the inability to make an 83(b) election would cause an increase in alternative minimum tax. In other words, the possible inability to make an 83(b) election could decrease an employee s ability to control the timing of when a stock first becomes subject to capital gains rates rather than ordinary income tax rates. The tax treatment of incentive stock options can be summarized by looking at the tax consequences at four points in time: At the time of grant, there are no tax consequences. The time of exercise may occur either before or after the time of vesting. If exercise occurs before vesting, there are no tax consequences, notwithstanding the potential to make an 83(b) election. If exercise occurs after vesting, the employee must recognize an alternative minimum tax preference item. There is no ordinary income tax liability, and thus no corresponding deduction for the corporation. 4

5 C. The Time of Vesting At the time of vesting, the employee must include the fair market value (at the time of vesting) of the shares less the option exercise price as an alternative minimum tax preference item if the option has already been exercised. At the time the employee disposes of the stock, the employee must pay capital gains tax on gains tax on the sale price less the option exercise price paid previously. However, if a disqualifying disposition is made ordinary income would result and the corporation would receives an ordinary tax deduction. A disqualifying disposition applies if the stock acquired through an ISO grant is sold: (a) before two years from the date of grant; or (b) before one year from the date of exercise. IV. PHANTOM STOCK OR STOCK BONUS AWARDS These plans refer to the award of compensation based upon the performance of the company s stock. When there is no public market or market valuation, a company may set a formulaic approach for determining the award. Since no property is involved (i.e. transfer of stock), the award is taxable as ordinary compensation to the employee. The timing of taxation will vary depending on when the employee s rights are nonforfeitable and whether the employee has actual or constructive receipt of the award. Companies frequently establish deferred compensation plans, referred to as Rabbi Trust plans, to delay the time when the employee is subject to tax. IV. CONCLUSION The type of stock incentives that would create the greatest total tax savings can only be predicted by comparing their effect on the tax situations of both the employee and the corporation. For example, if the corporation cannot benefit from deductions because it is not profitable, it may make more sense to use an incentive stock option because the fact that the corporation cannot take a deduction is mitigated. If on the other hand an employee is subject to alternative minimum tax and the corporation could benefit from the deduction, incentive stock options are likely to be a wasteful means of compensating the employee. 5