The grant of equity to employees implicates issues across several areas of the law, including tax, securities, corporate and contract law. Although an entire book could easily be written on the subject of employee equity grants, here are some of the initial questions and issues that employee equity grants frequently involve:
Will the equity awards be granted under an employer plan? Although companies sometimes grant equity on a one-off basis to employees, in most companies, the basic framework for making equity grants is set forth in an overarching written plan that is adopted by the company’s board of directors and is in many cases approved by the company’s stockholders. These plans are often referred to as stock option plans, equity incentive plans or stock incentive plans. These plans typically specify the types of grants that can be made under the plan, the maximum number of shares that may be granted, and other guidelines and rules relating to the grant of equity. Equity plans should be distinguished from employee stock ownership plans, which are tax-qualified employee benefit plans that buy and hold employer stock for the benefit of the plan participants.
What type of equity will be granted? Equity awards are typically made in the form of an individual written agreement or certificate indicating the type of award, the number of shares subject to the award and other relevant information. Equity grants are sometimes made in the form of direct grants of stock to employees. In other cases, equity is granted in the form of an option, which is a right to purchase shares of employer stock in the future for a pre-determined price. While direct equity grants and options tend to be the most common ways to grant equity, there are other types of grants that companies sometimes make. Stock appreciation rights are rights to receive the amount of the appreciation of a share of employer stock. Phantom stock is generally a bonus based on the value of an employer’s stock on a future date.
How do securities laws apply to employee equity grants? Generally speaking, federal and state securities laws require that the offer or sale of stock or other securities be registered with the Securities and Exchange Commission and relevant state securities agencies unless the offer or sale can be made under a statutory or regulatory exemption. This general principle applies even in the context of employee equity grants. When stock or options are granted to a small number of people in a company, it will be much easier to claim an exemption for the grant. However, as a company starts granting equity to a larger number of people, then there is an increased chance that an exemption won’t apply. This is why publicly held companies typically file an S-8 Registration Statement with the SEC to register employee equity grants. In the absence of such a registration statement, it is important to structure the grant under a securities law exemption with the advice of competent securities counsel.
What does “vesting” mean? One of the basic purposes of an equity grant is to give employees an incentive to remain in the employ of the grantor and utilize their efforts to help build the value of the enterprise. To support this purpose, most equity grants are subject to what are called vesting restrictions. In the case of a stock option, the vesting restrictions typically provide that an option cannot be exercised until the employee has remained with the employer for a specified period of time. Often the vesting restrictions will be staged over a period of time. For example, an option agreement may provide that one-fourth of the option vests on each of the first four anniversaries of the option grant date.
In the case of an outright grant of stock, the vesting restrictions usually provide that the granted shares cannot be transferred and are subject to forfeiture by the employee until the employee remains with the employer for a specified period of time. As with options, these vesting restrictions are often staged over a period of years. Stock that is subject to such vesting restrictions is commonly referred to as restricted stock. The vesting schedules of options or restricted stock are generally set forth directly in the award agreements or certificates.
When does the award expire or terminate? In the case of an option, the option award agreement will establish an expiration date after which the option cannot be exercised (this is usually between five and 10 years after the date of grant). The awards will also usually provide that if the employee ceases to be employed prior to the full vesting of the award, the unvested parts of the award will be forfeited and the employee will have a limited amount of time to exercise any vested options.
It’s not cash, but is it still taxable? Many people are surprised to learn that a grant of equity to an employee is, except in certain circumstances, a taxable event to the employee even though it is not paid in cash. That is, an outright grant of unrestricted stock to an employee is compensation for which the employer has a withholding obligation and on which payroll and income taxes are payable. The employee will have taxable income for federal income tax purposes equal to the fair market value of the equity received, which will be taxed at ordinary income rates. In the case of a grant of restricted stock, the employee does not have taxable income on the granted shares until the years in which the shares vest. This means that if the fair market value of the employer’s stock increases over time, the employee’s associated tax liability will correspondingly increase each year as the additional vestings occur. In this case, the employee could choose to file a Section 83(b) election with the IRS within 30 days of the grant. This requires the employee to pay, in the year of grant, taxes on all unvested restricted shares based on the fair market value of the shares at the time of grant, as opposed to paying taxes as the shares vest on the potentially higher share value at that time.
If equity is granted in the form of an option with an exercise price equal to the fair market value of the employer’s stock on the date of grant, there will generally be no federal income tax liability in the year of grant. However, whenever the option is exercised, the employee will be taxed on the spread, which is the difference between the exercise price and the stock value at the time of exercise. The spread is taxed at ordinary income rates and not capital gains rates.
If an option is granted to an employee under an equity incentive plan that is approved by the employer’s stockholders, has an exercise price equal to the fair market value of the employer’s stock on the date of grant, and if certain other IRS requirements are met, then the option can be granted as an incentive stock option. This option is given special tax treatment. It is not taxed at the time of grant or exercise, and assuming that certain conditions are met, the underlying stock can later be sold at capital gains rates.
Obviously, not all companies are organized as corporations. Some may be organized as limited liability companies, limited partnerships or other entity types. Additionally, some corporations may have elected to be taxed as “S-corporations,” which present special issues of their own when it comes to employee equity grants. The entity type is yet another consideration that could have a significant effect on how equity grants should be structured. For these reasons and in light of the issues discussed here, companies should always ensure that the structuring and granting of equity to employees is made in conjunction with experienced legal and tax advisors.
The information contained in this article is intended to provide useful information on the topic covered, but should not be construed as legal advice or a legal opinion. Also remember that state laws may differ from the federal law.