It used to be that if you wanted to start a corporation and the end goal was not to maximize shareholder value (or other typical corporate goals), you’d start a not-for-profit corporation. That’s no longer the case. Now in New York (and at least six other states) you can form a Benefit Corporation (a “B-corp”) which has other purposes besides making money. There are also other strategies you can use in a for-profit company to give it more of an egalitarian feel. We’ll discuss below.
Category: Stock Options
Another way to compensate employees of a corporation is to issue them Stock Appreciation Rights (“SARs” – not “sars – severe acute respiratory syndrome”, that’s something else). SARs grant employees, usually higher level executives, the right to receive stock and/or cash at a future date in an amount pegged to the increase in value of the corporation’s shares of stock over a certain time period. If the company’s share value increases, so to does the value of the SARs. SARs often are offered along with traditional stock options, although they are granted seperately (if done with stock options, sometimes you will see them called “Tandem SARs”).
We’ve covered the bare basics of stock options on this blog before. Here we will look into something that is all important when issuing stock options – that is the option’s exercise price. The exercise price is the amount an option holder needs to pay in order to exercise the option to receive the share of underlying stock. Most option holders will not exercise their options until the price of the underlying stock has risen higher than the exercise price, so that they can receive the shares and then sell on the open market for a profit. The IRS got keen on the fact that a company could issue stock options with an artificially low exercise price, which would allow the option holder to immediately exercise the option to receive the shares with the greater value and sell those shares, which is in effect as if the company paid cash to the option recipient. Hence Section 409A voted into effect in the American Jobs Creation Act of 2004. The reason stock options can receive beneficial tax treatment is because they are treated as deferred compensation. To get that treatment, stock options should only be granted with exercise prices at or above the fair market value (“FMV”) of the underlying shares of stock on the date of the option grant.
In a startup company, its common for certain employees to be compensated with some form of equity. When you incorporate, you would adopt a stock option plan and then issue options to the corporation’s employees to compensate them for their past services and to incentivize them to stay and keep up the hard work – make sure you vest!
With LLCs becoming ever more common, the owners of a startup organized as an LLC want to be able to compensate and motivate their employees and contractors in the same manner. They can do so by granting employees LLC profits interests.
There are qualified (a.k.a. “incentive”) stock options plans as well as non-qualified stock option plans. The basic difference is that incentive stock options receive special tax treatment, which is better from an employee’s perspective, but not necessarily from the company’s.
Incentive stock options are available for issuance only to employees. No income is reported when the employee exercises the option (with some AMT considerations), and the entire gain when the stock is sold can be taxed as long term capital gains (instead of regular income). Also, incentive stock options must be nontransferable, and exercisable no more than 10 years from grant, with an exercise price at least equal to the FMV at time of grant.
Non-qualified stock options result in taxable income to the recipient at the time they are exercised in the amount of the difference from the exercise price and the market value when exercised. Employers prefer non-qualified stock options because the company receives a tax deduction equal to the amount the stock receipient is required to include as income – the company is not allowed this deduction when using incentive stock options. Nonqualified stock options are issuable to anyone, may or may not have an exercise price and are transferable. We’ll explore the details in later posts.