Equity-Based Compensation: Tax Considerations

As the commentary around the IPO of two major social media companies revealed, tax consequences of equity-based employee compensation are not always straightforward and are sometimes poorly understood. Equity compensation structures are legion, with varying tax consequences for employees and employers. Complicating matters further, prescribed accounting treatment for equity compensation expenses, including measurement dates, differ for tax and financial statement reporting purposes.

An understanding of the tax consequences to the employees and the employer can help companies choose the optimal structure and instruments for their equity-based compensation plans. The following presents a brief outline of income tax accounting for equity-based compensation.

• The Internal Revenue Code (“IRC”) allows limited amounts of qualified (or “statutory”) stock options that may be eligible for special tax treatment, provided certain conditions are met. Qualified stock options can be structured as incentive stock options or employee stock purchase plans. Except in cases of disqualifying dispositions, employees are exempt from taxes when they exercise qualified stock options. Accordingly, qualified stock options generally do not give rise to a tax deduction for the employer company. Once the options are exercised, employees are liable for long or short term capital gains taxes upon disposition of the shares.

• Nonqualified grants may be structured as options, restricted stock, restricted stock units (“RSUs”), stock appreciation rights (“SARs”) or other arrangements with varying vesting (service) conditions and terms. Pursuant to ASC 718, Compensation – Stock Compensation, grant date fair value of the nonqualified stock options is recognized as compensation expense over the service period for financial reporting purposes. Employee tax assessments, however, are based on the intrinsic value of the awards at the settlement date – generally the exercise date for options or the vesting date for restricted stock grants. Tax deductions based on the intrinsic value of the grant are available to the company during the same period in which the employee recognizes income from the award. For the company, the difference in timing between tax and financial reporting gives rise to a deferred tax asset, which is recognized over the service period.

In addition, the stock prices underlying grant date fair value and settlement date intrinsic value are almost inevitably different. If the stock price increases between grant and settlement, the company recognizes any tax deduction in excess of reported compensation expense (a windfall) as additional paid-in capital. On the other hand, if the stock price declines between grant and settlement, the company recognizes a shortfall, which reduces the accumulated balance of (prior) windfall benefits. Any remaining shortfall (after accumulated windfall benefits are exhausted) is reported as an income tax expense.

• A recipient of nonqualified restricted stock awards may choose to pay income taxes based on fair market value at the grant date by making an IRC Section 83(b) election. In this case, increases in the stock price subsequent to the grant date are taxed at capital gains rates. The employee risks forfeiting the award if the vesting conditions are not met. If an employee makes an IRC Section 83(b) election, the company reports a tax deduction at the grant date, and records a deferred tax liability to be realized over the service period.

• Certain equity-based compensation instruments – including options, RSUs and SARs – could come under the purview of IRC Section 409a, engendering additional potentially punitive tax and reporting obligations for deferred compensation. In general, equity-based compensation plans can avoid this undesirable classification by structuring the award such that the exercise price is not less than the grant date fair market value of the underlying stock.

The foregoing is intended solely as a starting point for further exploration and discussion. If you are a corporate manager or director looking to institute an equity based compensation plan, please consult your tax counsel to understand all facets of such arrangements. We are not tax experts, but we do keep up to date with the valuation implications for varying equity compensation structures.

For both start-up and mature companies, Mercer Capital’s valuation experts assist in the measurement of grant-date fair value of equity-based compensation across a variety of industries. Call us – we would like to work with you to find the best equity compensation structure and provide a reliable opinion regarding grant date fair value.

Related Links and Additional Reading

• Twitter IPO Tax Tips Worth Tweeting (via Forbes)
• 8 Things You Need to Know About Section 409A (Mercer Capital)
• Employee Stock Options: Tax Treatment and Tax Issues (via Congressional Research Service)
• Guide to Accounting for Stock-based Compensation: A Multidisciplinary Approach (via PwC)