EQUITY COMPENSATION OVERVIEW OPTIONS, RESTRICTED STOCK AND PROFITS INTERESTS

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1 EQUITY COMPENSATION OVERVIEW OPTIONS, RESTRICTED STOCK AND PROFITS INTERESTS There are many equity compensation techniques, and they of course have varying tax implications. This memo discusses three widely used techniques that may have particular tax attraction, in part because they generally avoid the application of Internal Revenue Code Section 409A and generally afford the holder a capital gain opportunity with respect to the long-term holding of the investment. The first two techniques described below are used in C and S corporation, while the third technique can be used by noncorporate business entities, such as partnerships and LLCs. Options to acquire stock in corporations. The typical omnibus stock option plan provides for the grant of both incentive stock options ( ISOs ) and nonqualified stock options ( NSOs ). The discussion below explains the differences between the two types of options. ISO Requirements: ISOs are afforded special tax treatment, which, as explained below, may or may not be advantageous, and therefore must meet special requirements. 1. ISOs may be granted only to employees of the issuing corporation or its subsidiaries. Thus, an ISO cannot be granted to a member of the board of directors in that capacity, nor to an employee of an LLC or partnership. 2. The ISO must be granted pursuant to a plan that specifies both the total number of shares that may be subject to options and who is eligible to receive options. The plan must be approved by the shareholders within 12 months before or after the date it is adopted by the board of directors. 3. An ISO cannot be exercisable after the expiration of 10 years from the date of grant (five years in the case of an option granted to an owner of more than 10% of the voting power of the issuing corporation). 4. The option must be granted within 10 years after the first to occur of the plan s adoption or its approval by shareholders. 5. During the optionee s lifetime, the ISO may be exercised only by him, and by its terms it cannot be transferrable other than at death. Further, unless the employee dies or is disabled, the ISO can only be exercised while he is employed, or within three months after employment ceases. 6. The ISO exercise price must be at least equal to the fair market value of the stock on the date of grant (in the case granted to a more than 10% owner, it must be equal to at least 110% of the fair market value). {isonsors_mem; 1}

2 7. There is a limit on the maximum amount of ISOs that can first become exercisable by an individual in any calendar year. The limit is the number of shares corresponding to $100,000 divided by the per share fair market value at the time of the ISO s grant. Example: If all of the options that are ever granted to Alice Employee are granted when the company s stock has a fair market value of $20 per share, the maximum number of ISOs that can first become exercisable by Alice in any calendar year is 5,000. Thus, if Alice is granted an option for 50,000 shares at the $20 exercise price, her option could not vest (that is, become exercisable) more rapidly than at the rate of 5,000 shares per year (that is, 5,000 per year x $20 = $100,000 per year) if the option is to qualify in its entirety as an ISO. However, there is no restriction on Alice carrying over to a subsequent year and exercising in a subsequent year all of her ISOs that became exercisable in a prior year or years. Nor is there any problem with having a large number of NSOs becoming exercisable by Alice in the same year as ISOs. NSO Requirements: There are no specific tax requirements concerning NSOs; any option granted to a person in connection with his or her performance of services automatically is treated as an NSO if it fails to meet the ISO requirements or, even if it meets them, if by its terms it provides that it will not be treated as an ISO. The only requirements concerning NSOs are those imposed by the plan and by applicable local law. However, if the NSO exercise price is not at least equal to the fair market value of the stock on the date of grant, the NSO will be treated as nonqualified deferred compensation and taxed and penalized in accordance with Section 409A. As a result, it is unlikely that a company will issue an NSO with a discounted exercise price (except in the unusual case that it meets the Section 409A payment timing requirements by being exercisable only upon termination of employment or upon a date certain). Tax Consequences of an ISO to the Optionee: For federal income tax purposes, no tax event occurs when an ISO is granted. When an ISO is exercised, the optionee does not recognize any income for regular federal tax purposes. If he meets the ISO holding period requirements discussed below, he will recognize income for regular federal tax purposes only when he disposes of the stock that he received when he exercised the ISO. His income at that time will be measured by the difference between the excess, if any, of the sales price over the option exercise price, and will be treated entirely as long-term capital gain income. However, when the ISO is exercised the difference between the exercise price and the value of the stock at that time is treated as a preference item for purposes of the individual alternative minimum tax ( AMT ), which currently is imposed at a maximum rate of 28%. While the AMT is unlikely to be an issue for a rank-and-file employee, highly compensated individuals may be subject to the AMT (or become subject to it because of ISO exercises), with the result that they experience little tax advantage from receiving ISOs rather than NSOs. The better the performance of the company s stock, the larger the AMT preference item will be when the ISO is exercised, and therefore the greater the chance that the AMT will apply at that time. {isonsors_mem; 1} - 2 -

3 To the extent the AMT does apply, an AMT tax credit will be available to offset the regular tax inclusion that occurs when the stock acquired under the ISO is ultimately sold; in other words, the AMT can accelerate tax but will not give rise to a double tax. In order to receive the favorable regular tax treatment of an ISO that is described above, the optionee cannot dispose of the stock acquired upon exercise within two years from the date of the option grant nor within one year from the date of exercise (a Disqualifying Disposition ). As a practical matter, this means the employee will have to fund payment of the exercise price from some source other than selling the shares acquired or else at least some of the ISO benefit will be lost. If a Disqualifying Disposition does occur, the optionee will recognize ordinary income at that time based on the difference between the Disqualifying Disposition sales price and the option exercise price or (if less) the difference between the fair market value of the stock at the time of exercise and the option exercise price. If the stock has appreciated after exercise, the appreciation is taxed as capital gain income. Example: Betty Employee receives an ISO in 2015 that has a $20 per share exercise price. In January 2018, she exercises an ISO on one share when the shares are trading at $50, and six months after exercise sells the share for $60. Because Betty has not held the stock for one year, she has a Disqualifying Disposition. Betty is treated as having ordinary income in 2018 of $30, and a short-term capital gain of $10. No income tax withholding or social security (FICA) tax is due in connection with an ISO, even if a Disqualifying Disposition occurs. Tax Consequences of an ISO for the Issuing Corporation: The issuing corporation normally does not receive any tax deduction in connection with an ISO. However, if a Disqualifying Disposition occurs, the corporation receives a tax deduction equal to the ordinary income recognized at that time by the employee. In order to enable the employer to claim the deduction, a well-drafted ISO plan will require an optionee who has a Disqualifying Disposition to notify the company. Tax Consequences of an NSO to the Optionee: As with an ISO, an optionee does not recognize any income upon the grant or vesting of an NSO (assuming Section 409A is inapplicable). However, when the NSO is exercised, the optionee recognizes ordinary compensation income equal to the difference between the exercise price and the value of the shares at that time. This compensation income is subject to income tax withholding and social security taxes. (If the employee does not have sufficient other compensation income from which the company can withhold the required income tax, the company must find a way to require the employee to furnish it with cash so the company can meet its income tax withholding obligations. Buying back some of the stock as soon as the employee exercises is one way to do this, but obviously this reduces the employee s participation in future growth and may also give rise to a taxable dividend.) {isonsors_mem; 1} - 3 -

4 Once the employee has recognized ordinary compensation income under the NSO, he is treated like any other person who has purchased company stock: he has a holding period beginning on the date the compensation income occurs, and any further gain or loss will be based solely on changes in the stock s value from the time the compensation income was recognized, and will qualify as long-term or short-term capital gain or loss income. In some cases, the stock acquired upon exercise of an NSO is subject to a substantial risk of forfeiture, such as a vesting provision that requires the employee to sell it back to the company at cost if he fails to perform services for a certain period after the stock s acquisition. In that situation, the ordinary income event does not occur until the stock is transferred or the substantial risk of forfeiture lapses unless the employee makes a Section 83(b) election to be taxed at the time the stock is acquired (that is, at the time of option exercise). It is unusual for a corporation to issue restricted stock under an option; if the employer wishes to impose restrictions to require the employee to remain employed for some period in order to receive a benefit, for example the vesting restrictions typically are included in the terms of the option, rather than in the stock that is acquired upon exercise. For example, an option may not become exercisable until the employee has remained employed for a period of, say, three years, but the stock acquired upon exercise is immediately vested. Tax Consequences of an NSO to the Issuing Corporation: The employer will be entitled to a compensation deduction at the same time and in the same amount as the compensation income is recognized by the employee. As indicated above, the usual income tax withholding and social security taxes on compensation income will apply, so the company will have the cash flow issue of having to remit those funds to the IRS (and, possibly, to state tax authorities), and will be liable for its share of social security taxes that then apply. Reporting issues: Income recognized upon exercise of an NSO, together with any applicable withholding, must be reported on Form W-2 in the case of an employee or Form 1099-MISC in the case of a non-employee. Any compensation income recognized in the event of a Disqualifying Disposition of an ISO must be reported on Form W-2. If stock is transferred pursuant to the exercise of an ISO, the corporate employer must report this on Form Comparison of ISOs and NSOs: The advantage an ISO may have is that for certain employees it will produce two tax benefits: deferral of income (because tax is not paid until the shares acquired are sold, rather than having income at the time of option exercise); and a conversion of ordinary income to capital gain (because any run-up in value between the grant date and exercise date will be taxed on sale as long-term capital gain if the holding period requirements are met, rather than ordinary income as in the case of an NSO). These possible individual tax advantages may largely disappear in the case of an employee who will be subject to the AMT on the entire spread between exercise price and value at the time of exercise, or one who exercises and then sells so quickly that he has a Disqualifying Disposition. There is also a small advantage in that income arising from ISOs is not subject to social security tax. The principal disadvantage of an ISO is that the company does not receive a compensation deduction for the spread between exercise price and value at the date of {isonsors_mem; 1} - 4 -

5 exercise, as it does in the case of an NSO. If the issuing corporation has a meaningful amount of positive taxable income, the corporate compensation deduction will have a value roughly equivalent to the tax burden on the employee exercising the NSO. (A typical combined federal and state effective corporate tax rate is about 40%, which is similar to if not less than the typical combined overall marginal tax rates on high income individuals.) Accordingly, it is almost always more tax efficient for a taxpaying corporation to issue NSOs rather than ISOs. If it wishes, it should be possible for the corporation to compensate the optionee with additional cash compensation so he is in at least as good a position as if he had received an ISO instead, and the company is significantly better off. Example: Assume General Corporation is in a 40% combined federal and state tax bracket and Charlie Employee is in a combined 45% bracket and subject to a combined 28.8% capital gain rate. Further assume he is granted options that when exercised have a value $100,000 in excess of the exercise price. (a) If the options are ISOs, the government will collect a net $28,800 from the transaction, the eventual capital gain tax on the spread. Unless the AMT applies, this tax will be deferred until the stock is sold. Charlie therefore nets $71,200. (b) If the options are NSOs, assume that General Corporation also pays Charlie a $60,000 bonus. Charlie s situation is as follows: Option spread $100,000 Bonus 60,000 Ordinary Income $160,000 Tax at 45% (72,000) Net $ 88,000 General Corporation s situation is as follows: Compensation deduction $160,000 Tax Savings at 40% $ 64,000 Cash paid to Charlie (60,000) Net Increase in Cash $ 4,000 Thus, both Charlie and General Corporation can be better off with the NSO alternative. Restricted Stock. Rather than granting stock options an employer may issue stock to an employee or other service provider. Stock can be issued without any payment on the part of the recipient, or it can be sold to the recipient for some or all of its fair market value. Furthermore, the recipient can pay the purchase price with a note. In order for the transaction to be respected for tax purposes, the service provider must either pay cash or sign a note that is recourse for a significant part. {isonsors_mem; 1} - 5 -

6 Stock not subject to any vesting restrictions is immediately taxable as compensation income at its then fair market value. Any further appreciation or depreciation is thereafter taxed at capital gain rates. Often, however, the company has a right to repurchase any unvested shares for an amount equal to the lesser of what the holder paid or the then fair market value of the shares if the holder ceases to perform services before a certain date (for example). In that event, taxes are generally deferred until vesting. The company may also have a right to repurchase vested shares for their fair market value, or the company may waive all of its repurchase rights, in which case the holder would be immediately taxed on the then value of any unvested shares. Under federal income tax rules, a service provider must pay tax on the difference (if any) between his purchase price and the fair market value of the shares at the time the shares vest. (Obviously, if there are no vesting conditions, this means at the time of their acquisition.) In the case of shares subject to vesting, a service provider may instead file a Section 83(b) election to be taxed at the time the shares are acquired, even if they vest later. The election must be filed with the IRS within 30 days of the transfer of the shares. Once the Section 83(b) election is filed, any increase in value of the shares after the transfer date will be subject to tax only at capital gain rates, and only upon the holder s disposition of the shares. If the holder makes a Section 83(b) election and is required to resell his unvested shares, he will only be entitled to a capital loss equal to the amount paid (if any) for the stock. Example: Joe Zabo is awarded 50 shares of his employer s stock, currently worth $100 per share, on January 2, Joe does not pay anything for the stock and the stock is subject to three-year cliff vesting, meaning that he can keep the shares only if he remains employed through January 2, If on that anniversary the stock is worth $200 per share and he becomes vested, Joe will have compensation income equal to $10,000. He will then have a basis of $10,000 in the stock and his capital gain holding period will begin to run as of January 2, If instead Joe made a Section 83(b) election within 30 days of the original transfer, he would pay ordinary income tax on only $5,000 (the then value of the shares over the amount paid). His basis would be $5,000 and his capital gain holding period would begin to run as of January 2, Should Joe leave before January 2, 2018, he would forfeit the stock and would not be entitled to any tax deduction for the income previously recognized (since he paid nothing for the stock). As noted, a Section 83(b) election can be made if the shares are subject to vesting restrictions, even when the service provider pays full value for the shares. Example: Pamela Professional purchases 50 shares of her employer s stock for $100 per share, a total purchase price of $5,000. She pays $2,500 in cash and $2,500 by signing a 10-year nonrecourse note. The shares are subject to a five-year vesting schedule. Assuming that Pamela and the company believe the true fair market of the shares is no more than $5,000, Pamela would be well advised to file a Section 83(b) election. The election will report no tax due because Pamela has paid the full fair market value of the shares. If the IRS were {isonsors_mem; 1} - 6 -

7 to successfully challenge the valuation position taken by Pamela in the election, she will owe additional tax for the year of purchase based only on the difference between $5,000 and the value of the shares that the IRS establishes. The tax will be imposed at compensatory (ordinary) income rates. In general, when the holder recognizes compensation income, the company will be able to take a compensation deduction. If the holder is an employee, there will also be withholding obligations. Profits interest. The IRS has recognized, in two revenue procedures and in proposed regulations, that a person s receipt of a partnership profits interest in consideration of the performance of services is not a taxable event, nor is the vesting of such an interest treated as taxable. For purposes of this treatment, a profits interest means an equity interest in a business entity taxed as a partnership, which may include an LLC, that, under the terms of the relevant agreements, would receive zero proceeds if the entity were liquidated at the time of its receipt. It does not include an interest that is disposed of within two years of receipt, or in an entity with a predictable steady stream of income, such as a partnership whose assets consist of a portfolio of high-quality bonds. In light of this authority, it would not seem necessary for the recipient of a profits interest subject to vesting to file a Section 83(b) election (since the IRS position is based on the view that neither the receipt of the profits interest nor its vesting is a taxable event). Nevertheless, practitioners normally recommend the filing of a Section 83(b) election in these circumstances as a protective matter, for two reasons. First, the revenue procedures and proposed regulations are not technically of any precedential value; in theory, an aggressive IRS agent could take a position inconsistent with them, or the IRS could simply change its view with retroactive effect. Secondly, the conclusion in any particular instance that an interest would receive zero in a liquidation on the date of receipt may depend on uncertain valuation issues and on a reading of ambiguous partnership/llc agreement provisions. The Section 83(b) election assures the holder that, even in the worst instance, he or she would never be taxed on ordinary income at the time of vesting based on increases in value after the receipt of the interest. Note, by the way, that a person who holds a profits interest in the partnership/llc for which he is performing services should be treated as a partner (rather than an employee) for federal income tax purposes, even before the profits interest vests. This means that the individual will receive a Schedule K-1 (rather than a Form W-2), will be responsible for estimated tax payments (rather than paying taxes through the withholding system) and may not enjoy a handful of nontaxable benefits available to employees. The individual should, however, be entitled to capital gain tax treatment on an exit from the business, whether by disposing of the profits interest or on a flow-through basis of income when the partnership/llc sells its business or assets. Copyright 2014, Sullivan & Worcester LLP This Advisory is intended to provide a general overview of certain political, economic and legal issues. Because sound legal advice must necessarily take into account all relevant facts and developments in the law, the information you will find in this Advisory is not intended to constitute legal advice or a legal opinion as to any particular matter. {isonsors_mem; 1} - 7 -

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