Should I Offer Stock Options to My Employees?
Betterment’s Head of Tax, answers commonly-asked questions that small business owners often have about stock options.
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In this first article, Eric Bronnenkant, Betterment’s Head of Tax, answers commonly-asked questions that small business owners often have about stock options.
Can you briefly explain what stock options are and how they work?
Stock options are a common way for privately-held start-up companies to incentivize employees. They are awarded to employees, granting them the right to purchase shares, usually over a period of time according to a vesting schedule. The predetermined stock purchase price is the strike (or exercise) price, paid when the buy option is exercised. The hope is that the shares will be worth more in the future.
How do stock options incentivize employees?
Employees are incentivized by their paycheck, of course, but stock options can help supercharge that incentive in that they provide equity potential. They can help employees consider how their decisions and actions contribute to the company’s success.
With stock options, when the company does well, employees also benefit. So compared to pure cash compensation, stock options do a much better job of aligning the company’s interests with the employees’ interests. They may also help with employee retention because they are usually awarded over a period of time.
What are the different types of stock options?
There are many different types of equity compensation, but the two types of stock options are non-qualified stock options and incentive stock options. The biggest difference is whether the discount of the stock option (the current market value less the strike price) is treated as compensation to the employee.
For a non-qualified stock option, the discount is considered to be compensation to the employee at the time of exercise. For the incentive stock option, that discount is generally not considered to be compensation. So the real benefit of the incentive stock options over non-qualified options is the potential to convert what would otherwise be treated as compensation into capital gains. Capital gains generally have a lower tax rate than compensation taxes.
What would cause an employer to choose one over the other?
I would say that the most common reason that an employer would choose the incentive stock option is that they don’t need to pay the employer portion of payroll tax on the compensation that would be paid on the non-qualified side. And it ultimately shifts all of the tax benefits and burdens over to the employee.
In addition, the tax deduction that comes with the non-qualified stock options is not really valuable if your company isn’t profitable, which is the case for most early-stage companies. However, once your firm becomes profitable, having the tax deduction on non-qualified options becomes much more valuable.
When might it make sense for companies to consider offering stock options?
One of the most attractive reasons for using stock options for an employer is that, up front at least, it doesn’t cost any money to issue the stock options. So it allows an employer to potentially provide a lower salary in exchange for more potential equity upside.
Businesses that are just starting out typically have very limited resources and are trying to maximize how they’re going to use those resources. Compensation is usually a large part of that decision making process, especially for service-based companies. One way to reduce that cash compensation cost is to shift that mix from 100% cash to, for example, 75% cash and 25% stock options. That frees up cash to hire other employees or invest in new products for the business.
In other words, stock options maximize the use of the available cash resources.
Even companies that are just starting out will want to do some kind of benchmarking to be sure they can attract the kind of talent they want and so may determine that stock options make sense. After that, I would say you would want to evaluate your equity compensation arrangements on an annual basis.
How are stock options taxed?
For the employer, taxation is related to which type of option you’re talking about and whether the discount is treated as employee compensation.
As mentioned earlier, when non-qualified stock options are exercised, any discount (where the current market value is greater than the strike price) is treated as compensation to the employee. In addition, any future appreciation is treated as a capital gain. For the employer, employee compensation is a deduction to the business.
With Incentive Stock Options, there is no tax deduction for the employer.
For the employee, in general, there is no income tax on exercise. The entire gain upon sale is treated as a capital gain. However, the employee may owe alternative minimum tax (AMT) upon exercise but that is dependent on many other factors.
Are there other equity compensation structures that companies may wish to consider?
Late stage start-ups, say those that are pre-IPO, may wish to consider restricted stock units (RSUs) which means employees who work for a certain period of time will typically be entitled to something regardless of the performance of the stock. With stock options, the stock has to appreciate in value in order for the employee to benefit.
Would firms who want to go this route typically convert existing options to RSUs?
It really depends on the kind of goals of the employer. If the employer wants to make sure that employees are getting rewarded for working for whatever their vesting requirement is, then they may be likely to convert over to the RSUs. But typically, RSUs are used for new equity grants and the original stock options would be left alone.
How do stock options fit into an overall benefits package?
Small companies, especially those in highly competitive industries or geographic areas, have to consider their overall compensation package to attract and retain top talent. Stock options may be one method to do that, but more traditional benefit components shouldn’t be overlooked and can serve as good complements to stock options. For instance, 401(k)s are almost a “must-have” benefit these days, but not all 401(k)s are the same. Some are much better at engaging employees, helping them save more for retirement and becoming more financially confident and secure—all of which could be especially important if options don’t pay off.
Betterment is not a tax advisor, nor should any information herein be considered tax advice. Please consult a qualified tax professional.
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