Andersen Tax

Andersen Tax

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Compensation & Benefits

With respect to closely-held businesses, as with any business, it is critically important to align the interests of the founders with the early employees and investors. That is why choosing the right type of equity compensation can play a crucial factor in the success of your company.

What are the different types of compensation?

Restricted Stock & Options

Grants employees the right to purchase shares at fair market value or at discount, subject to vesting terms.

Conditions:

  • Most commonly, the vesting restriction lapses if the employee continues to work for the company for a certain number of years, often three to five. Time-based restrictions may lapse all at once or gradually.
  • Any restrictions could be imposed, however. 

Tax Implications:

  • Employees have the right to make a "Section 83(b)" election and they are taxed at ordinary income tax rates on the "bargain element" of the award at the time of grant. Any future change in the value of the shares between the filing and the sale is then taxed as capital gain or loss, not ordinary income.
  • Employee who does not make an 83(b) election must pay ordinary income taxes on the difference between the amount paid for the shares and their fair market value when the restrictions lapse. Subsequent changes in value are capital gains or losses.
  • Employer gets a tax deduction only for amounts on which employees must pay income taxes.

Incentive Stock Options

Grants employees the right to purchase a certain number of shares of stock at an established price with the advantage that no income is reported when the option is exercised and, if certain requirements are met, the entire gain when the stock is sold is taxed as long-term capital gains.

Conditions:

  • Only available to employees
  • Must be held for at least one year after the exercise date and for two years after the grant date
  • Can only exercise $100,000 of stock options in a calendar year
  • Exercise price must not be less than the market price of the company's stock on the date of the grant
  • Must be granted under a board approved written plan document that has been approved by stockholders within 12 months of plan adoption.
  • Must be exercised within 10 years of the date of grant
  • Employee cannot, at the time of grant, own stock representing more than 10% of voting power of all stock outstanding, unless the option exercise price is at least 110% of the fair market value and the option expires no later than five (5) years from the time of the grant.

Tax Implications:

  • Employee pays long-term capital gains tax on the total increase in value between the grant price and the sale price. The company does not take a tax deduction when there is a qualifying disposition.
  • Enables employee to defer taxation on the option from the date of exercise until the date of sale of the underlying shares
  • Enables employee to pay taxes on his or her entire gain at capital gains rates, rather than ordinary income tax rates

Non-Qualified Stock Options

Grants employees the right to purchase a certain amount of the companys stock for a fixed price after a defined period of time resulting in additional taxable income to the recipient at the time that they are exercised.

Conditions:

  • Deferred vesting conditions require taxpayer to comply with special rules for all types of deferred compensation.

Tax Implications:

  • Dependent on how you report your stock option transactions.
  • Spread on exercise is taxable to the employee as ordinary income, even if the shares are not yet sold. Subsequent gain or loss on the shares after exercise is taxed as a capital gain or loss when the optionee sells the shares.
  • Employer is allowed to take a tax deduction equal to the amount the recipient is required to include in his or her income.