Equity compensation can be very effective in attracting and retaining top talent. It’s a key tool for building or rewarding loyalty and commitment, without using precious cash resources. Staff will know their direct actions are affecting the company’s value and that, if there’s an exit sale, they’ll share in the proceeds. There are many types of equity compensation, from phantom stock and stock appreciated rights, to incentive stock options (ISOs), nonqualified stock options (NSOs), and restricted stock. No matter the form of equity compensation you offer, keep in mind that tax planning for stock grants and options is more complex than planning for cash salaries and bonuses.
The key with enticing potential employees with stock options is to offer plans comparable to your competitors; however, the talent pool may not have a sophisticated understanding of the value of stock options. For example, if you offer 500 shares, but a key competitor offers 1,000 shares, a prospect is more likely to choose the competitor. Even if your 500 shares are valued higher, the prospective employee has already made their decision based on the sheer volume of shares.
If you’re considering adding stock options to your benefits package, or already include them, there are several tax and legal concerns to address. Equity compensation programs are complex and require thorough legal, accounting, and tax planning. For most situations, an independent valuation is strongly recommended to comply with financial statement reporting and tax requirements. This valuation must also stay current — 12 months is a common period of time used to establish that a value is current. Be sure to engage a trusted advisor to help structure your equity compensation plan and ensure it meets all compliance requirements.
83(b) election for restricted stock
When restricted stock (i.e., stock that is not vested and will be forfeited upon certain specified events) is received, you can make an IRC Section 83(b) election to recognize income. While this has risks (i.e., you can’t claim a deduction on the noncash income recognized when the stock is forfeited later), it can result in the appreciation of the stock being taxed at capital gains rates when the stock is ultimately sold. This election is very beneficial to a startup company if stock is granted when the value is low and the stock value significantly appreciates. To be effective, you must file an election statement with the IRS within 30 days of acquiring the restricted stock and include the statement in your income tax return.