Building the Right Compensation Plan for Your Tech Company

At a glance

• The main takeaway: Equity incentives are an important component of any tech company’s compensation plan, but it can be challenging to know which equity incentive plan is best for your company and your employees.
• Impact on your business: A strong compensation plan is a great tool for attracting and retaining top talent, whether you are a start-up or a growth-stage company.
• Next steps: Assess the benefits alongside the risks and weigh your options with the help of a knowledgeable advisor. Schedule a consultation with Aprio’s Fintech team today.

The full story:

A competitive compensation plan is one of a company’s top strategies to attract and retain top talent. This has long been true in the tech world, where equity incentives and other perks primarily drive the job market for both start-up and growth-stage tech companies. While this compensation strategy has a proven record of success, there are still many considerations that tech companies should consider when assessing stock options and weighing them against other equity incentives.

It is essential that both employers and employees understand the different kinds of equity incentives and their related tax benefits, their implications (and potential benefits), and their pitfalls.

Choosing the right type of stock option

There are two primary types of stock options popular among tech companies that are looking to provide equity incentives: Incentive Stock Options and Nonqualified Stock Options.

Both have pros and cons, especially as they relate to tax implications, which can help you determine which is best for your company and your employees.

1. Incentive Stock Options (ISOs)

• ISOs are designed to comply with provisions of the Internal Revenue Code (IRC). Your employees do not have to pay income tax on the issuance or the exercise; instead, income tax is only paid when the employee sells the shares.
• While employees who exercise an ISO don’t have to pay regular income tax up on exercise, they do have to report alternative minimum taxable income for the difference between the fair market value and the exercise price (the spread). The resulting tax is called Alternative Minimum Tax (AMT) and if paid, it can offset future capital gains tax.
• For ISOs, the spread is not subject to employee or employer social security and Medicare tax.
• If the stock exercised is held one year from the date of the exercise, it will qualify for long-term capital gain treatment.
• If the options are exercised while the company shares are eligible as Qualified Small Business Stock (QSBS) under IRS Code Section 1202, the gain on sale could be exempt from income tax on gains up to $10 Million.
• ISOs carry strict holding requirements. If the shares are not held for two years from the date of grant and one year from the date of exercise, the ISOs will lose most of the favorable tax benefits. This event is known as a disqualifying disposition (DD). These dispositions are commonplace, as many employees exercise their ISOs just before the company’s sale. This treatment throws the option into the “nonqualified” bucket, which we dive into next…

2. Non-qualified Stock Options (NSOs)

• Simply put, these stock options do not comply with ISO provisions of the IRC, which means they do not qualify for the same beneficial tax treatment available for ISOs.
• When an employee exercises an NSO, they must recognize income from the spread. This income will be reported as compensation up exercise and is, therefore, subject to all employee and employer payroll taxes.
• To complete the exercise of NSOs, the employee must remit to the company both the exercise price and the related withholding tax due on the spread.
• Like ISOs, if the employee holds the stock for one year from the date of exercise, the sale will qualify for long-term capital gain treatment.
• The employee’s basis in these shares will be the exercise price, plus the phantom income triggered on the exercise date, or better said the FMV at exercise.
• If held five years, these shares can also be eligible for QSBS benefits as discussed above.
• To the extent the employee recognizes income from the exercise of a NSO, the company receives a deduction to reduce taxable income. This is not the case with ISOs, unless the ISO turns into a DD.

Can I exercise my stock options before they are vested?

Most stock options awarded have a multi-year vesting schedule. Some companies allow their employees to exercise options before vesting occurs.

The risk to the employee is that if they depart the company before vesting occurs, they would lose the money they paid for the shares that are not vested. This could result in a capital loss to the extent of the basis in those shares.

The benefit is tremendous for both ISOs and NSOs, since the holding period will start upon exercise and any phantom income from an NSO exercise or AMT from the ISO exercise would be lower. This is because the exercise can be done when the FMV is the same or very close to the strike price. 

The clock for QSBS purposes starts at exercise date, allowing the employee a better chance of taking advantage of these benefits.

The critical aspect of any early exercise will be an election under IRS Code Section 83(b), which must be received by the IRS within 30 days of the exercise date. Not making this timely election could invalidate the benefits of an early exercise and could end up costing the employee and the employer more in taxes in the future.

Why stock options may not be the right incentive for your company

While ISO’s and NSO’s are the most chosen equity incentive, they aren’t the only equity incentive methods. Other tech companies might find these alternatives appealing:

1. Stock Grant

• Early-stage companies are in a unique position to grant stock, which is usually restricted outright to select employees and advisors. 
• The FMV of the shares is taxable and generally, we only recommend this if the recipient can afford the tax cost for the FMV of the shares at the award date. 
• The employee should make an election under IRS Code Section 83(b) for this strategy to work tax efficiently. Not making a timely election can be very costly to the employee and challenging for the company to manage.
• The earlier in a company’s evolution, the better fit for this alternative.

2. Restricted Stock Units (RSUs)

• RSUs are common for public companies and highly valued tech companies positioning for an IPO. An RSU is the grant of an instrument mirroring a company’s stock to employees. It is typically given as a reward for performance, recognition of length of service, or as an incentive to remain with the company.
• Recipients of RSUs don’t have any tax liability on the award of the RSU.
• When the RSUs vests, the company replaces the RSUs with actual shares.
• The FMV of those shares are taxable immediately.
• If the company is private, the company usually has an arrangement in place to buy back some of the shares. This is also to give the employee enough cash to fund the taxes due in connection with this triggering event.
• If the company is public, the company generally arranges for the employee to sell some or all of these shares.
• Be cautious if putting this mechanism in place for a public company whose shares are thinly traded or a private company without the liquidity to fund buy-back of at least 40% of the shares to cover the employees’ tax due.

3. Phantom Equity/Stock

• Phantom stock, also known as phantom equity, ghost shares, shadow stock, stock appreciation rights (SARs) is an equity incentive plan more commonly used with closely held companies, versus Venture Capital and/or Private Equity (PE) backed companies.
• Employees receive Phantom Equity in the form of a Grant or Unit which mirrors shares in the company’s at its current FMV. There is usually a vesting period, though none is required. 
• The employee never exercises or purchases shares, and the employee never becomes a shareholder.
• Upon sale of the company, or sometimes another liquidity event, the value of the phantom shares is compared to the inherent strike price of the award times the vested units/shares, and results in a taxable bonus. 
• The company receives a tax deduction for this same amount. The tax result is similar to a non-qualified stock option that is exercised and sold in connection with a sale.

Evaluating other tax considerations

If your tech company is considering any of these equity incentive plans, you need to be knowledgeable about the costs, benefits, reporting, and tax obligations both for the company and your employees receiving these incentives.

Understanding IRC Section 409A is critical for companies offering each of the incentives discussed herein. Section 409A governs the tax treatment of deferred compensation plans and provides strict guidelines on how companies value and tax equity incentives.

Any stock option with an exercise price less than the fair market value at the date of the grant are subject to 409A rules, which can have dire consequences for the employees, while also incurring a 20% excise tax penalty.

The alternatives herein can be mixed and matched allowing a company to use all of these features.

The bottom line

Working with a knowledgeable tax advisor can help identify the most advantageous alternatives while ensuring you remain in full compliance with all applicable tax rules. If you are considering any of the alternatives discussed herein, Aprio’s Fintech team can work with you to help develop the right plan for your company. 

Our intent is to first understand your business goals and objectives to retain and recruit the people needed for your company to succeed. We provide you with guidance from a tax perspective, accounting perspective, and we share with you the trends that companies in similar places in your lifecycle are doing.

Moreover, Aprio can assist companies with employees in multiple countries that may have other planning considerations.

Schedule a consultation with Aprio to get started.

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