Options or Restricted Stock - How Should I Compensate Employees?

Business Law Blog
Authored by Bryan Springmeyer
The information on this page should not be construed as legal advice.

Employee compensation plans of non-public companies often issue restricted stock grants or options pursuant to the approved plan. In preparing the plan or issuing awards, founders may often deliberate between stock options and restricted stock. The major factors for consideration are the value of the company and the tax issues related to valuation.

Granting options, which are contractual rights to purchase stock at a certain price (the strike/exercise price), often entails startups seeking independent valuations. This is because the IRS, via §409A of the IRC, and certain states including California, tax nonqualified deferred compensation in addition to normal income tax. This generally means that options earned in one year but exercised in another are subject to the tax to the extent that the value of the stock, at the time the option was granted, exceeds the strike price (the purchase price at which option holders are allowed to exercise their options). To avoid the tax, the startup must, upon making the award, set the strike price at least at a price representing the value of the company. Unless the options are incentive stock options ("ISOs" defined at 26 USC §422(b)) Section 409A requires this valuation be done by a person with significant knowledge and experience or training in performing similar valuation. The regulations also allows independent appraisal by approved methods.

Restricted stock may more easily avoid the need to seek independent (and expensive) appraisal. In these grants, stock is given to the employee, but the company maintains a contractual right to repurchase some of the stock if the employee leaves (time vesting – more common) or doesn’t meet performance metrics (performance vesting – less common). However, the feasibility of using restricted stock is predicated on a nominal valuation of the company. The vesting stock will likely trigger Section 83a of the IRC, which recognizes as income the FMV of property transferred for services provided. If the company has a significant fair-market value (FMV), the income the restricted stock holder will receive will be significant, and the stock of a private company will be difficult or impossible to liquidate to pay the resulting tax burden. This will not make your employees happy. If the company has a nominal value, the stock recipient can make an election pursuant to §83(b) to recognize the income upon receipt of the stock, rather than the default recognition upon vesting. Usually, the recipient will purchase the restricted stock, so no income is recognized.

In short, options will likely require an expensive 409A valuation, but the alternative, restricted stock, is not optimal unless the company has a nominal value and an 83(b) election is made, or there is some ability to liquidate stock to pay the tax burden.

Why should employers care? For starters, you’ll make your employees mad. Additionally, employers are required to withhold taxes due under §409A and are subject to penalties for failing to do so.

Why should employees care? As it turns out, the IRS does not really care whose fault non-optimal tax treatment is - If your employer gets it wrong, you’ll still be personally liable for the resulting tax burdens.

Related Pages:

Tax Issues for ISOs, NSOs, and Restricted Stock for Employees and Consultants
Restricted Stock in Startups
Section 83(a)
Founder Considerations for Vesting Stock
Section 83(b) election letter generator