On April 1, 2010, the Center for Tax Law and Employee Benefits welcomed Kelli Toronyi, a partner at Michael Best & Friedrich LLP, who presented “Executive Compensation Issues,” as part of the Employee Benefits Lunch & Learn Series. Toronyi practices employee benefits, executive compensation, employment, business, and tax law, and serves as an adjunct professor with the Center’s LLM in Employee Benefits program.
Kelli Toronyi, a partner at Michael Best & Friedrich LLP, presents “Executive Compensation Issues.”
“Toronyi provided a comprehensive overview of how equity compensation fits in the executive compensation structure.”
Toronyi provided a comprehensive overview of how equity compensation fits in the executive compensation structure. Equity compensation packages generally include a combination of appreciation awards, which the employee holds until they gain value, or full-value awards, which give the employee the awards at their full value. Appreciation awards include incentive stock options (ISOs), non-statutory stock options (NSOs), and stock appreciation rights (SARs). On the other hand, full-value awards include restricted stock, restricted stock units (RSUs), and phantom stock.
From a tax perspective, there are three key events: option grant, option exercise, and the sale of the underlying shares of stock. ISOs are options granted to employees in a plan that meets the requirements of Internal Revenue Code (IRC) §422. When an optionee holds more than one ISO, only options worth $100,000 of the underlying stock, measured as of the grant date, become exercisable during the calendar year, and are entitled to ISO tax treatment. Toronyi cautioned that this limitation tends to confuse employees. ISOs are particularly attractive to employees, because the employee is only taxed once when the underlying stock is sold (if the ISO holding period is met) at the long-term capital gain/loss rate. However, ISOs are not as attractive to the employer, because the employer never gets a deduction.
By contrast, NSOs are options granted to employees or non-employees under a plan that does not meet the requirements of §422. Toronyi noted that NSOs are taxed twice—once upon exercise of the option at the ordinary income tax rate and again at the sale of the underlying stock at the capital gain/loss rate—and thus are not as attractive to employees. However, employers receive a deduction on the exercise date equal to the amount of ordinary income recognized by the recipient.
SARs are promises to transfer property, and provide the recipient with the right to receive the appreciation in value of the stock over a specified time. Unlike a stock option, the employee is not required to pay the exercise price, so the employee automatically receives the proceeds without paying anything. Tax consequences for SARs are similar to NSO stock options.
Elise Linden JD candidate
Full-value awards include restricted stock, RSUs, phantom stock, and performance shares. Restricted stock is awarded subject to a substantial risk of forfeiture. Employees may elect to recognize income at the time of the award, pay ordinary tax, and then recognize capital gain/loss upon the subsequent sale of the stock. However, one caveat to the IRC §83(b) election is that, because the stock is subject to a risk of forfeiture, if the employee terminates employment before selling the stock the employee loses the award on which they have already paid taxes. RSUs and phantom stocks are promises to transfer shares of company stock, but no actual stock is granted. Upon vesting, either the company delivers the shares of stock or settles in cash. Performance shares are awards of actual stock shares or stock units contingent on the achievement of pre-determined performance objectives.
Tax consequences for these four options are essentially the same. The employee recognizes ordinary income when the award vests or the shares are delivered, and if settled in stock, the employee recognizes capital gain/loss on the subsequent sale of the stock. Upon delivery the employer gets a deduction equal to the amount of ordinary income recognized by the recipient.