Accumulated Earnings and Deferred Compensation

Stock options

A popular form of deferred compensation for executives is stock options.

The Distance Learning Center offers 2 courses that cover stock option plans in greater detail:

Course 20: The Basics of Equity Compensation
Course 22: Black-Scholes Valuations

These discuss the 2 types of employee stock options:

1. Incentive stock options (ISO)
2. AND
2. Nonqualified stock options (NSO)

Taxes. Each is taxed differently. There are 3 points at which a taxable event can take place:

1. time of grant
2. time of exercise (e.g. purchase of the stock)
3. time of sale

• ISO. A qualified plan under IRS rules. There are no tax consequences at grant time, but a potential alternative minimum tax consequence is triggered by the exercise. In addition, when the shares are sold, there is a tax consequence. If the sale meets the holding period restrictions, the tax is the capital gains tax. Otherwise, the tax will be the ordinary income tax. In the latter case, the company receives a business expense deduction equal to the ordinary income realized by the employee.
• NSO. A plan that does not qualify for favorable tax treatment. A tax consequence is likely upon the occurrence of any of 3 events. However, a tax liability is unlikely at the time of the grant, the first event, as long as the exercise price is not set below the market value on the date of the grant. Upon exercise of the option, the recipient pays ordinary income tax on the difference between the current market value and the exercise price - the spread. At this time, the company can take a business expense deduction equal the spread. Upon sale of the stock, there is a capital gains tax on the difference between the market value at the time of sale and the market value of the stock at exercise, if the stock is held for over a year, otherwise the gain is taxed at the ordinary income tax rate. If the exercise and the sale are at the same time, there is a minimal or no capital gain involved.

The above discussion assumes that the employer is a listed corporation, so a “current market value” is readily available. When the company isn’t publicly traded, the taxation situation becomes more complex, as we’ll discuss in the next section.

Q: Does Section 409A Impact Stock Options?

A: Yes, it does.

The good news is that stock options can be structured to be exempt from 409A penalties. The IRS regulations provide a tax exemption for a stock option at time of grant if its exercise price is not lower than the fair market value of the option on the grant date. However, if the exercise price is lower than the stock value at time of grant, then even before exercising their options, the employee may have to pay income tax on the difference between the current stock value and the lower than fair market exercise price and, in addition, pay a 20% penalty on that difference.

Private companies may be especially impacted by Section 409A because it's difficult to value their shares. Some of the issues include:

• They may be unable to rely on their most recent funding event to establish stock values for option grants.
• A 409A stock valuation differs significantly from a typical enterprise valuation because it requires modeling of the capital structure and allocation of the total enterprise value to common stock.
• Preferred stock and certain classes of common stock will not qualify for the stock option exemption under the regulations.