Employee Stock Option - Will ESO’s Gain Popularity

If you’ve been following the financial news media, the war for talent has intensified.  The search for good employees that obsesses tech companies has spread to other industries.  After almost nine years of mostly sluggish expansion, the U.S. economy shifted into high gear and is creating jobs at a record pace.  With the labor market tighter than it has been in decades, workers finally have their moment.  As employers seek to recruit and retain talent, will ESO’s gain popularity?

An editor from the HR Technologist makes the case for ESO’s.  “The last few decades have been a virtual roller coaster ride for stock options as benefits.  After a sudden surge in popularity during the 90s, the dotcom bubble burst, making millions of shares worthless and disappointing a large workforce.  Yet, success stories like Starbucks keep the dream alive.  The company is famous for giving employees in every tier, from the humble barista to management, a chance to be compensated in kind.  The upside is that it helps foster investment and ownership at every level.  This is something Starbucks knew and even accentuated by calling all its employees ‘partners’.”

So, are ESO’s soon to be popular again?

Helping you Understand ESO’s

At Henry V. Kaelber, CPA, CFP®, CGMA, we are committed to providing our clients and readers with every advantage when trying to preserve and grow their human, intellectual and financial wealth.  This article asks if ESO’s will gain popularity by companies to share ownership, attract and retain staff. And, explains how employees should view them.

Henry V. Kaelber, CPA, CFP®, CGMA is a Charlottesville, Virginia CPA firm providing quality tax accounting, tax preparation & tax planning services for individuals, business, trusts & estates. We also offer business consulting services and private equity structuring support.

What Are ESO’s and Why Might They Gain Popularity?

Before I continue, it probably helps to explain that ESO is an acronym (abbreviation) for Employee Stock Options.  Employee stock options are a type of equity compensation.  A company may award these options to their employees and executives.  Generally, they give an employee the right to buy company shares at a specific price, within a certain time period.

For employee’s, ESO’s can provide a number of advantages.  They provide an opportunity to share in the company’s growth and success.  They boost morale through pride of ownership.  And, depending upon the plan, they may offer some tax advantages when sold or converted to cash.

For employer’s, ESO’s can provide a number of advantages.  They can motivate employees to help grow the business.  They can incentivize top employees to stay with the company.  And, they can provide a cost efficient capital raising mechanism for the employer to finance growth.

The popular thinking today is that cash bonuses only serve to reward employees for taking undue risks in their efforts to generate profits.  this is because cash bonuses can sometimes foster moral hazards and conflicts of interest.  Management consultants commonly refer to this as an “agency problem”.  The agency problem is a conflict of interest inherent in any relationship where one party is expected to act in another person’s best interests.  This conflict arises when company employees use their power and authority for their own benefit instead for the shareholders.  However, this is not only a problem that pervades corporations.  Clubs, churches and in Government suffer this problem as well.

A Lesson From the Past

What contributed to the worst economic downturn in most of our lifetimes?  We all might agree that it came about as a result of a “bursting” of a credit lending “bubble”.  But, what created the bubble and why did it burst?  The popular explanation describes how “greedy” people facilitated lending other people’s money.  The money was lent without regard to whether or not the borrowers could repay.  This agency problem fell apart when investors began to realize that no one was looking out for their interests.  As a result, investors headed for the exits.  What ensued was a loss of confidence in our financial system which brought about the worst recession in my lifetime.  This is an over-simplification of the cause.  And, individuals, business and Government quite broadly share in the blame.

Despite this, if employees are awarded equity, or options on equity, their interests become aligned with the interests of the shareholders.  So, the use of ESO’s offer a great “free-market” way of ensuring against the kind of short-term thinking that contributed to the busted credit lending bubble many of us experienced.

For a growing company, ESO’s can align employees with shareholder interests and offer a viable source of cost efficient capital to finance that growth.  How so?

An ESO Example

Let’s take a look, at a simplified illustration of how an ESO creates alignment with employees and shareholders.  As well as providing the company a source of capital.

In this example, let’s say that XYZ Company awards stock option contracts to one or more of its employees.  The company’s shares can be bought and sold on a stock exchange.  XYZ’s stock is currently worth $10 per share.  And the Company’s Board and shareholders have adopted a plan that allows it to issue stock options.  Each currently issued stock option gives the holder the right to purchase 1 share of XYZ Company’s common stock for $10 within the next ten years.  The ESO’s are subject to a vesting period requirement.  XYZ awards 1,000 stock options to Employee A in reward for his/her positive efforts over the past year.  The company expects Employee A to continue such successful performance in the future.

By the way, vesting period is the period of time before shares in an employee stock option plan are unconditionally owned by an employee.  So, let’s assume that the 10% of the stock options vest immediately.  And the remaining amount vests 30% annually over each of the next three years.  Hence, 100% of the stock options currently awarded are available for conversion into common stock after three years.

After the stock options are awarded to Employee A, assuming XYZ’s stock price is still at $10 per share, the 1,000 options awarded have zero intrinsic value.  For this scenario, intrinsic value is the difference between XYZ’s Stock price ($10) and the options exercise price ($10) – because $10 minus $10 equals zero.  However, the option does have value to Employee A because of the 10 year right to purchase XYZ stock at $10 per share.

How the Employee’s Interests Become Aligned With the Shareholders

Now, let’s fast forward three years and assume that XYZ’s stock is trading at $25 per share.  Employee A’s fully vested stock options now have an intrinsic value of $15,000 ([$25 – $10] times 1,000 share options).

At this point, I hope it is easier to see how Employee A’s financial interests are aligned with those of the shareholders.  As the Company’s share price increases in value, so does the value of Employee A’s stock options.

But, how does this help XYZ Company raise capital?  Let’s say that Employee A wants to convert the stock options into cash.  Or, he/she wants to manage his/her future income tax burden.  In order for Employee A to pursue either of these avenues, the options need to be converted into stock.  When the option is exercised, Employee A will pay $10 per share to XYZ.  If all are exercised, Employee A will pay $10,000 and XYZ will issue Employee A 1,000 shares of its stock.  Then, Employee A can sell the shares in the open market or hold on to them.  Holding them long term achieves potential income tax savings.  In short, XYZ raised capital because the exercise price went into XYZ’s coffers.

ESO’s and Income Taxes

Above, I discussed how Employee A might want to manage the income tax effect.  This supposes that Employee A is a US citizen.  ESO’s do have some income tax advantages; and, under the US Tax Code, the advantages vary.  The degree of tax savings are greatest if the ESO plan qualifies under certain rules and the employee follows the prescribed procedure upon exercise and sale.

Under the tax laws, when you receive an option to buy stock as payment for your services, you may have income when you receive the option, when you exercise the option, or when you sell or otherwise dispose of the stock (acquired through the exercise of the option).  Generally, the timing, type, and amount of reportable income depends on whether you receive a non-statutory stock option or a statutory stock option.

Now, we’re going to delve deeper into Nonstatutory (Nonqualified) and Statutory Stock Options. The differences between the two are fairly clear.  Generally the statutory stock options receive beneficial tax treatment, if the options qualify.  So that you don’t fall asleep on me, I won’t go too deeply into tax law.

Stock options can be a valuable employee benefit. However, the tax rules are complex. Due to the complexity, it is important that you speak with a tax professional soon after you receive them to determine what your tax obligations are.  With ESO’s, it is always wise to plan in advance if you want to maximize the value.

To keep this simple, let’s continue with the facts of the illustration above:

Example A:  the ESO’s are Non-Qualified Stock Options

As reflected above, the ESO’s had no intrinsic value when granted.  And we’ll just assume that the time value of the options was not determinable when issued.  In this case, the options do not create any taxable income when granted.  Instead, Employee A will have taxable income when he/she converts (exercises) the options for stock.

Let’s suppose that Employee A converts all 1,000 options after 3 years.  Also, assume that XYZ’s stock is trading at $25 per share.  Upon exercising the option, Employee A will have $15,000 of taxable income.  XYZ needs to report this income on Employee A’s Form W-2.  And, this income is subject to Social Security and Medicare taxes as well.  Also, at conversion, XYZ can expense $15,000 as compensation expense.  Upon which, XYZ pays the employer share of payroll tax and receives $10,000 in cash (the exercise price times the number of options exercised).

As a result, Employee A owns 1,000 shares of XYZ stock with a cost basis of $25 per share (the $10 paid plus the $15 included in income).  Employee A can either immediately sell the stock for cash or hold the shares as an investment.  In either scenario, he/she would report the sale as a Capital Gain or Loss transaction on Schedule D.  And, the holding period begins on the date Employee A exercised the option.

Example B:  the ESO’s are Qualified Stock Options

Now, let’s suppose that XYZ crafted their stock option plan in accordance with US Tax Code.  Specifically, section 422 (of Title 26) relating to Incentive Stock Options.

Qualified stock options can receive favorable treatment from federal taxes.  A Qualifying Stock Option holder will not normally realize any taxable income upon the grant or exercise of an ISO.  Employee A reports the taxable income only when he/she sells the stock.  At this point, the entire gain is taxable.  So, the first tax benefit is the delaying of a taxable event.

Then next tax benefit is a reduced tax rate on the gain.  Currently, the tax rate for long-term capital gains is typically 15% or 20% depending on your income.  Whereas, the tax rate for ordinary income is often higher.  You can qualify for this preferential tax rate by following certain timeline rules.  If you hold the shares for two years after grant and one year after exercise, you only pay capital gains tax on the ultimate difference between the exercise and sale price.

If you sell, transfer, gift, or short the stock too soon, you lose the tax benefits of ISOs that occur with a qualifying disposition.   Disqualifying disposition is the legal term for selling, transferring, or exchanging ISO shares before satisfying the ISO holding-period requirements.  Your company receives a tax deduction when you make a disqualifying disposition equal to the amount of ordinary income you recognize for your early sale. It needs to report this income on your Form W-2. Therefore, companies use various methods to track stock sales.

The AMT Caveat

There is one important caveat, however.  You may owe AMT in the calendar year you exercise your qualified stock options.  The individual alternative minimum tax (AMT) operates alongside the regular income tax.  It requires some taxpayers to calculate their liability twice—once under the rules for the regular income tax and once under the AMT rules—and then pay the higher amount.

The amount of AMT you may have to pay is related to the spread between the grant price and the exercise price of your qualified stock options, multiplied by the amount of shares you exercise.  You may, however, be able to recover the AMT paid in future years.  When the amount paid under the AMT exceeds what would have been paid under normal tax rules that year, this AMT excess becomes a “minimum tax credit” (MTC) that can be applied in future years when normal taxes exceed the AMT amount.

It is also important to note that employees are not the only persons who can receive stock options.  Some companies grant these options to non-employee Board members and independent contractors for their services.  In these cases, the options granted are always Non-Qualifying Stock Options.

So, while the taxation of ESO’s are a little challenging to grasp, they can be an excellent tool for their ability to: (a) tie employee compensation to company performance and (b) provide a cost efficient capital raising mechanism for the employer to finance growth.

About the Author

Henry V. Kaelber, CPA, CFP®, CGMA