As you review your compensation options, you may want to make greater use of a long-term incentive plan, such as stock options, phantom stock or other types of deferred compensation arrangements. In recent years, these long-term incentive plans have assumed a larger role in companies' compensation packages because they not only have tax advantages, but they help retain key executives and managers.
For regular corporations, stock options in particular have become a very popular strategy. When stock options are offered, executives, managers or even regular employees are given the option of purchasing the company's stock in the future at the prices set when the options are granted. If the price of the stock increases, the recipients benefit because they can buy low and sell high.
"Stock options have really come to the forefront in the past 10 years because of the marketplace,' says Rebecca Autry, a manager with accounting firm Grant Thornton LLP in Cincinnati. "Because of the labor shortage, business owners are trying to attract and retain quality people, and [stock options are] one of the mechanisms used to achieve that."
The tax benefits of issuing stock options are particularly good. "The company records no expense for providing compensation through stock options, plus it gets a tax deduction for providing compensation that way,' says Christopher Rich, president of Lyons Compensation & Benefits LLC in Waltham, Massachusetts.
There are essentially two types of stock options: nonqualified options and incentive options (ISOs). Nonqualified options represent the bulk of options issued today. They trigger ordinary income tax on the appreciation captured when individuals exercise the options.
For example, if an employee receives an option to purchase a company's stock at $10 per share, and after several years, the current fair market value increases to $15 per share, the $5 appreciation is compensation to the recipient and is taxed as income. This amount is also subject to Social Security and Medicare taxes. The $5 increase is deductible by the company as a compensation expense. Of course, instead of buying and selling, the employee can choose to hold the stock, which may continue to increase in value.
The tax basis for calculating future stock gains is the market value of the stock at the time the option was exercised. Only appreciation of the stock above that level is taxed when the recipient decides to sell the stock. If he or she holds it for more than a year, the profit will be treated as a long-term capital gain, which is subject to a maximum 20 percent tax rate.
When recipients sell stock gained through ISOs, on the other hand, the options are taxed at capital gains rates rather than the higher tax rates that apply to ordinary income. There is no taxation at grant or at exercise. There are, however, certain restrictions on the terms of an ISO and how long it must be held. Autry points out that from a company perspective, ISOs are not as favorable taxwise as nonqualified options because of the various rules governing them.
Both types of options have no cash value when they're given out because they can't be converted to cash or stock until they vest. The time it takes to vest depends on the requirements of each plan, but it generally ranges from two to five years.
For the most part, stock options work best with public corporations and have less of a role with S corporations and limited liability companies (LLCs), Autry says. Why? Because owners of closely held S corporations and LLCs aren't usually as interested as public corporations are in giving away ownership.