Overview of US Stock Option Plans

In the United States, granting employees equity is a common way for companies to incentivize, reward, and retain talent. There are several methods and instruments available, depending on the company structure, stage, and objectives. This document details an overview and worked examples of the primary options:

Profits Interest

A profits interest is a form of equity compensation unique to LLCs. A profits interest gives the holder their proportionate share of the business value growth from the time interests are granted until redemption or sale. Therefore, the profits interest does not allow the recipient to participate in the net equity value of the Company on the date of its issuance. Instead, it only allows the recipient to participate in future appreciation in the net equity value of the Company.

Taxability of Profits Interest

Employee Taxation

Profits interest represents equity in the LLC, and the later sale or redemption of the equity interests generally generates taxable income at favorable long-term capital gains rates (assuming the taxpayer meets the 12-month holding period requirement).

This is because profits interests represent a share in future profits and growth, which are generally unknown. In addition, comparable interests in partnerships have been found by courts to have only speculative value that cannot be accurately quantified for purposes of imposing tax. It is anticipated this treatment will also lend itself to C corporations for U.S. tax purposes. Please note, this is normally only relevant for private companies as publicly traded companies most likely would assign value to these rights.

Employer Taxation

The employer’s tax implications when issuing a profits interest are primarily related to compliance and administration. While no immediate tax deduction is available, the company avoids the tax and payroll implications of traditional compensation.

Non-Qualified Stock Options (“NQSO”)

NQSOs are extremely flexible, allowing the employer to grant options to employees and non-employees, and set the term of the options for periods of more than ten years. However, NQSOs are not as tax favorable as they generally result in the employee’s taxable income being included on the option’s exercise date as discussed below.

Employee Taxation (assuming no section 83(b) election)

Grant Date: Employee is not deemed to have received compensation for tax purposes on Grant Date.
Exercise Date: Assuming options are vested upon Exercise Date, the employee will be taxed on the difference of the Fair Market Value (“FMV”) of the shares less the price paid by the employee. This amount will be included in gross income and taxed at ordinary income tax rates, subject to federal income tax withholding requirements and US payroll taxes for employees.

Note, in the event the shares are not vested at exercise date, the employee would normally be taxed at the time those shares subsequently vest.

Section 83(b) Election

Any person to whom substantially nonvested property is transferred in connection with the performance of services can elect under section 83(b) to report income resulting from transfer in the year that the property’s transferred.

An 83(b) election of NQSOs allows the recipient to exercise and pay tax on their pre-vested NQSOs. When you exercise your NQSOs, you’re taxed on the spread between the exercise price of the NQSO and the price at exercise at that time. The goal of using the 83(b) Election is to turn what may be future price appreciation that would normally be taxed at ordinary income tax rates into long-term capital gains. The risk of the 83(b) election is that when you file the election, you are exercising the unvested shares that you currently do not own. To obtain the rights, you will need to meet the requisite vesting schedule and/or requirements. The taxpayer also assumes the risk that the stock price does not increase in value.

Timing of Election

The election must be made not later than 30 days after the date of transfer. The 30-day requirement is mandatory, and a taxpayer can’t wait to see if the value of the underlying stock goes up before an election is made to report income in the year the property was transferred. However, the election may be made before the date of transfer.

Employer Taxation

Section 83 determines how an employer should deduct stock-based compensation in the US. Section 83(h) provides that upon transfer of property in connection with the performance of services, the “person for whom services were performed” (i.e., employer) may claim a tax deduction under section 162. The amount of the employer’s deduction should equal the amount of that included in the gross income of the person who performed the services. If the employer timely reports the income on the employees Form W-2 or Form 1099 for independent contractors, the person is deemed to include the gross compensation in gross income and the company may deduct the compensation on its tax return.

Restricted Stock

Share of stock granted to an employee which sale is prohibited for a specified period of time (i.e., non-vested shares). These are normally nontransferable and subject to forfeiture under certain conditions, such as termination of employment or failure to meet either corporate or personal performance benchmarks. The restricted stock also generally becomes available to the recipient under a graded vesting schedule that lasts for several years.

Employee Taxation

Section 83(b) election is eligible for Restricted Stock. The 83(b) election allows the employee to report the Fair Market Value of their shares as ordinary income on the date they are granted, instead of when they become vested. This election can reduce the amount of taxes paid upon the plan because the stock price at the time the shares are granted is often much lower than at the time of vesting.

Section 83(b) elections MUST be filed within 30 days of the grant. The IRS does not provide extensions for the 30-day filing period. Absent a Section 83(b) election, the employee has ordinary income inclusion upon vesting of Restricted Stock. The entire amount of the vested stock must be included as ordinary income in the year of vesting. This amount is determined by subtracting the original purchase price or exercise price of the stock (sometimes $0) from the fair market value of the stock on the date of vesting. Upon future exit of the restricted shares, this will be reported as a capital gain or loss on the future sale price less the shareholder’s tax basis in the restricted shares.

Incentive Stock Options (“ISO”)

Similar to NQSOs, ISOs provide the terms under which the Company will sell the stock to the recipient. ISOs are more tax efficient for recipients, however they are generally not as flexible as NQSOs and must meet certain statutory requirements to qualify for the favorable tax treatment.

Employee Taxation

The manner in which the employee disposes of the shares acquired through the ISO will determine the taxability to the employee.

Qualifying Disposition

A qualifying disposition is when an employee that receives stock, acquired through an ISO, is disposed of more than:

Two years from the grant date; and
One year after the stock was transferred to the employee (usually the exercise date).

Taxation of Qualifying Disposition

If an employee sells the shares obtained from the exercise of the option through a qualifying disposition, the individual will only pay long-term capital gain taxes on sale proceeds that exceed the option’s exercise price. Although an employee does not recognize taxable income until the shares are sold or otherwise disposed of, the employee will have to make an adjustment to reflect alternative minimum tax (“AMT”) income in the year of exercise. The AMT adjustment is the excess of the FMV at the date of the exercise over the option price and becomes part of the AMT basis of the stock. A Form 3921 is filed with the IRS to report the exercise by the employee of the ISO.

Disqualifying Disposition

A disposition that fails to meet the statutory holding-period requirement of a qualifying disposition will be considered a disqualifying disposition. In a disqualifying disposition, the exercise of the option will be treated as though the option was a NQSO. Even though employment taxes will not be due, ordinary income tax will be imposed on the lesser of:

The stock’s FMV on the exercise date less the exercise price; or
The stock’s sales proceeds less the exercise price.

If the amount realized on a future sale exceeds the sum of the amount paid for the shares and the amount of income recognized on the disqualifying disposition, the gain is generally capital gain.

The employer is not required to withholding income tax on any portion of the ordinary income or capital gain that is triggered upon disposition. However, the employer is required to report the compensation income on the employee’s Form W-2.

Employer Taxation

If the employer grants an ISO, it will receive a tax deduction only upon a disqualifying disposition. If there is a disqualifying disposition, the employer will be entitled to a tax deduction if the employee recognizes ordinary income at the time of the sale and the employer reports the income (i.e., including in Form W-2)

ISO Requirements

To qualify as an ISO:

ISOs may be granted only to employees. The option must be granted to an individual in connection with that person’s employment by the corporation granting the option (or by a related corporation).
The ISO may only be granted on the employer’s stock. The option must be for the purchase of stock of the employer or a related corporation. ISOs cannot involve a partnership interest.
The option must be granted under a formal plan and approved by Company shareholders. The plan must be approved by shareholders within 12 months before or after the date the plan is adopted by the corporation.
- The plan must include:
  - The maximum aggregate number of shares issuable; and
  - The employees or class of employees who are eligible to receive options.
- Options must be granted within 10 years of plan adoption or shareholder approval.
ISO plans may not last longer than ten years and an option exercise period cannot be longer than 10 years from grant. ISOs cannot exceed 10 years from the grant date (5 years for 10%+ shareholders).
ISOs must have a FMV exercise price. The exercise price of the option must not be less than:
- Must be at least the stock’s fair market value (FMV) on the grant date.
- For 10%+ shareholders, the price must be at least 110% of FMV.
ISOs cannot be transferred except for certain circumstances.
- ISOs cannot be transferred, except by will or inheritance.
- Only the employee can exercise the option during their lifetime.
Only a limited number of ISOs may be granted. An employee can only receive ISOs exercisable for up to $100,000 FMV of stock (based on grant date FMV) in any calendar year. Excess is treated as non-qualified stock options (NQSOs).
ISOs must be exercised within three months of an employee’s termination. The option holder must be employed by the granting or related corporation from the grant date until three months before exercising the option. If employment ends, the option must be exercised within three months, or within one year if termination is due to death or permanent disability.

Phantom Shares

Phantom shares, also known as shadow stock, are a form of employee compensation that mirrors the value of actual company shares without conferring any ownership rights. Unlike traditional stock options or grants, phantom shares do not involve issuing real equity. Instead, they represent a promise by the company to pay the employee a cash or stock equivalent of the value of a specific number of shares upon the occurrence of a predetermined event, such as a vesting date, company sale, or IPO.

Phantom share plans are particularly attractive for companies looking to provide equity-like incentives without diluting ownership or granting direct control to employees. These plans are commonly used by privately held companies, startups, and businesses operating under an Employer of Record (EOR) arrangement where traditional equity compensation may not be feasible.

Employee Taxation

From a taxation perspective, phantom shares are generally treated as ordinary income for employees when paid out, which simplifies tax compliance compared to traditional equity plans.

Employer Taxation

For employers, the payouts are deductible as a compensation expense, making them a financially viable alternative to issuing actual equity.

Valuation of Stock Options

Section 409A provides that the FMV of stock as of a valuation date is the “value determined by the reasonable application of a reasonable valuation method” based on all the facts and circumstances. A valuation method is reasonable if it takes into account all available information material to the value of the corporation and is applied consistently. A valuation may be determined to be unreasonable if it:

Fails to reflect information available after the date of calculation that may materially affect value; or
The value was calculated with respect to a date more than 12 months earlier than the date on which it is being used.

The IRS may successfully challenge the FMV by simply showing that the valuation method or its application was unreasonable. Section 409A does provide three Safe Harbor valuation methods for which the IRS may only successfully challenge the FMV established by use of a Safe Harbor by proving that the valuation method or its application was grossly unreasonable. The Safe Harbor options include:

Valuation by Independent Appraiser
Reasonable Good Faith Written Valuation of a Start-Up
Formula-Based Valuation

Due to the consequences of not being section 409A compliant, companies operating an EMI option plan in the UK will not be able rely on the HMRC-approved EMI valuation for US purposes as the valuation principals are different.

Internal Revenue Code Section 409A Compliance

IRC Section 409A limits the flexibility of NQSOs. Section 409A determines when an employee is taxed for stock-based compensation awards and also provides a broad definition of nonqualified deferred compensation plans and provides rules related to the timing of elections and distributions under deferred compensation plans.

The regulations confirm that ISOs and NQSOs are not deferred compensation and not subject to section 409A if the plans meet the following requirements:

Must be granted on stock that is “service recipient stock”;
Have an exercise price that is (or could be at some point in the future) at least equal to the stocks’ fair market value on the grant date;
Have a fixed number of shares on the grant date;
The receipt, transfer, or exercise of the option is subject to taxation under section 83; and
Does not defer the employee’s income tax to a date after the exercise of the option.

If these criteria above are not met, the option generally will be considered to be deferred compensation and therefore subject to the rules of Section 409A. Section 409A imposes restrictions on the timing and form of deferral elections, the timing of distributions/payments and the use of certain trusts to fund the arrangements. If the requirements are not met, the individual is subject to accelerated taxation, enhanced underpayment interest, and an additional 20% tax.

Worked Examples

Below are examples of the most common equity compensation arrangements mentioned above using the assumptions provided below.

Assumptions:

$8 FMV of Stock at time of Grant: 12/31/2022
2-year vesting period – Eligible to be exercised: 12/31/2024
$12 FMV of Stock at time of Vesting
Stock is exercised when vested
$15 FMV of Stock at time of Sale

Profits Interest

‍Event

Tax Considerations

Profits Interest Granted: $0 FMV

No tax consequences when stock granted

Annual increase in value of shares

No tax consequences as no income event occurs

Share Sold to Third Party: $7 FMV

Long-Term Capital Gain* on $7 FMV (difference between value increase from date granted and date sold)

Footnotes: *Long-Term Capital Gain only applies to capital assets (i.e., exercised stock options) if held for 12 months or greater.

Non-Qualified Stock Options (NQSOs)

‍Event

Tax Considerations

Option Grant: $8 FMV of Stock *

No tax consequences when stock granted

Vest and Exercise: $12 FMV

$4 Ordinary income inclusion on spread between FMV at Exercise vs. strike price.

Share Sold to Third Party: $15 FMV

Long-Term Capital Gain** on $3 (difference between $15 FMV and tax basis of $12)

Footnotes: *Please ensure the options are not subject to Section 409A. Discounted options could subject the holder to 409A penalties. **Long-Term Capital Gain only applies to capital assets (i.e., exercised stock options) if held for 12 months or greater.

Restricted Stock

‍Event

Tax Considerations

If no Section 83(b) election filed

Restricted Stock Grant: $8 FMV

No tax consequences unless Section 83(b) election filed by recipient

Vest: $12 FMV

Each vesting period, the recipient will have ordinary income inclusion equal to the FMV

Share Sold to Third Party: $15 FMV

Long-Term Capital Gain on $3 (difference between $15 FMV and tax basis of $12)

If Section 83(b) election filed

Restricted Stock Grant: $8 FMV

Recipient has immediate income inclusion equal to FMV of Restricted Stock on date of 83(b) election

Vest: $12 FMV

Each vesting period, the recipient will have no ordinary income inclusion due to 83(b) election

Share Sold to Third Party: $15 FMV

Long-Term Capital Gain** on $7 (difference between $15 FMV and tax basis of $8)

Footnotes: *Section 83(b) election has inherent risks and benefits. For example, if the recipient forfeits the Restricted Stock or the value of the Restricted Stock decreases prior to vesting, the recipient will have unnecessarily paid taxes. In the event of a forfeiture, you get no tax loss for the amount previously included in your income. **Long-Term Capital Gain only applies to capital assets (i.e., exercised stock options) if held for 12 months or greater.

Incentive Stock Options (ISOs)

‍Event

Tax Considerations

Option Grant: $8 FMV of Stock **

No tax consequences when stock granted

Vest and Exercise: $12 FMV

No ordinary tax consequences when stock is exercised. AMT income inclusion for difference between FMV and exercise price. Employee must use cash to exercise.

Share Sold to Third Party: $15 FMV

Long-Term Capital Gain*** on $7 (difference between $15 FMV and tax basis of $8)

Footnotes: ***Long-Term Capital Gain only applies to capital assets (i.e., exercised stock options) if held for 12 months or greater.

Phantom Shares

Grant Date: December 31, 2022, with 1,000 phantom shares granted.

Event

Tax Considerations

Option Grant: 1000 phantom shares granted

No tax consequences at the time of grant since no income or payout is realized.

Vest and Exercise: 1,000 phantom shares fully vest and become exercisable.

There are still no tax consequences at the vesting date because the payout is deferred until a sale or other triggering event.

Share Sold to Third Party: $15 FMV

1,000 shares × $15 FMV = $15,000 total cash payout to the employee. The entire payout is treated as ordinary income inclusion for the employee in the year of the sale.

Conclusion

In conclusion, US stock option plans offer diverse and flexible methods for companies to incentivize and retain talent while aligning employee interests with long-term business goals. Each option has unique characteristics, tax implications, and regulatory requirements that must be carefully evaluated based on the company's structure and strategic objectives.

To maximize the benefits of these equity compensation tools while minimizing risks, clients should ensure compliance with relevant laws and regulations, including Sections 83 and 409A of the Internal Revenue Code. Additionally, professional guidance from qualified tax and legal advisors is essential to navigate the complexities of these plans and to address the specific needs of both employers and employees.

It is important to note that these stock option plans are typically available under a Professional Employer Organization (PEO) arrangement. Under a PEO structure, the client company retains the flexibility to implement and manage such plans. However, under an Employer of Record (EOR) arrangement, the EOR becomes the legal employer of record, and as such, the ability to offer and administer these equity-based compensation options may be restricted or unavailable. Clients must assess their employment structure needs carefully to ensure alignment with their compensation and incentive strategies.

Overview of US Stock Option Plans