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The Good, the Bad, and the Ugly: Compensation Issues Faced by Government Contractors (Part 2 of 3)

Posted in Corporate, Capital, and Finance

This entry is the second of a three-part installment on types of deferred compensation and will briefly explain the positive and negative aspects of using stock options and restricted stock grants as means of providing deferred incentive compensation to employees.

A stock option is a right granted to an employee or other person to purchase stock at a fixed price.  The recipient of an option can typically exercise the option after the underlying stock price has increased in value, allowing the recipient to purchase more valuable stock at the discounted fixed price at some point in the future.  An option can be either a statutory stock option, sometimes referred to as an incentive stock option (or ISO), or a nonstatutory or “nonqualified” stock option (or NQO).  To qualify as an ISO, an option must be granted by a corporation to an employee with an exercise price equal to or greater than fair market value of the covered stock, and must be issued pursuant a written plan containing certain provisions described in the IRS regulations.  All options that do not meet the ISO requirements are NQOs by default.  While NQOs may be structured and exercised in a manner similar to ISOs, the federal tax treatment to the recipient of these different types of options can be substantially different.

Good:

  • Stock options are easily understood by most employees, and provide a clear incentive to help grow the value of the business.
  • Stock options can be structured to vest over time or upon the occurrence of certain events.
  • Stock options may enable employees to exercise the option and simultaneously sell the underlying stock to a third party without paying out of pocket.
  • ISOs provide a tax advantage to the employee by deferring taxation on the difference between the sales price of the stock and the exercise price until the stock is sold.
  • NQOs can result in a deduction by the employer, to the extent the employer

Bad:

  • ISOs do not generate a tax deduction for the employer.
  • ISOs may only be issued to certain employees, and the number of ISOs that can be issued each year is limited.
  • ISOs are subject to certain holding period requirements that can nullify some tax benefits to the employee if not properly followed.
  • NQOs can force the company to determine the value of the underlying stock when any transfer restrictions lapse, even when the value is not easily determinable.
  • The difference between the market value and the exercise price NQOs is taxed as ordinary income to the employee when any restrictions on the transfer of the stock lapse.

Ugly:

  • Options issued below fair market value can have disastrous tax consequences to the recipients.
  • NQOs can be subject to punitive the excise tax on deferred compensation under Code Section 409A (imposing a 20% excise tax on certain deferred compensation).
  • ISOs, although tax friendly, can be subject to the Alternative Minimum tax.
  • As with other types of equity compensation, some types of government contracting companies cannot effectively use options, due to restrictions contained in the SBA regulations.

A restricted stock grant is a grant of stock carrying certain restrictions by a corporation to a third party.  For instance, the stock may only become fully vested (i.e. not subject to a substantial risk of forfeiture) after an employee has completed a number of years of service with the company, or after the company has reached certain designated milestones.

Good:

  • The company is entitled to take a compensation expense equal to the then fair market value of the restricted stock when the risk of forfeiture lapses.
  • Vesting can provide easy incentives for certain, targeted goals.
  • The employee will not be required to recognize income until the risks of forfeiture lapse, although employees can elect to recognize the income from the grant at the time of the grant when the stock price is low and pay tax on a lower amount.

Bad:

  • Some employees may not understand the risk of forfeiture concept, making restricted stock more suitable for executive or management-level employees.
  • The holding period for capital gains determinations only begins to run when the employee recognizes income from the grant.
  • Dividends are taxed as ordinary income, rather than capital gains, until the employee recognizes income.

Ugly:

  • As with options, some types of government contracting companies cannot use restricted stock grants, due to SBA restrictions.
  • If the stock value drops after an employee has recognized income, the employee will have paid taxes on the gain without receiving the benefit.
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