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Stock options are a popular means of compensation for start-up technology companies. The reasons include their low initial cost to the cash-strapped start-ups and their potential to multiply in value if the venture is successful. But stock options carry burdens and penalties for both employees and companies that should be understood in advance. This article explores issues affecting both sides in relation to stock options and other forms of equity compensation. Stock options are rights granted by companies to acquire shares in the company at a specified price, the exercise or “strike” price. Stock options can be issued for no consideration, at essentially no immediate cost to a company (and its investors). They have the advantage of aligning the interests of the company and the employees who receive options, with the effect of committing the employee to the long-term success of the company. Although such rights may be granted with immediate effect, they typically “vest” over time. After the options vest, their holder may elect to continue to hold them or to pay the exercise price and receive stock in exchange for the options. QUALIFIED AND NON-QUALIFIED Stock options are distinguished, for tax purposes, as “incentive stock options” (or “ISOs”), which are qualified for special tax treatment, and non-qualified stock options (or “NSOs”). Neither NSOs nor ISOs are taxable to the recipient when they are granted. Shares acquired upon the exercise of ISO options are also not taxed at the time of their exercise. In contrast, shares acquired through the exercise of NSOs are taxed at ordinary income rates on the spread between the exercise price and the fair market value of the shares on the date of exercise. Generally, shares acquired through the exercise of ISOs are taxed only upon the sale of such shares, at capital gains rates, upon the difference between the sale price and the exercise price. ISOs therefore offer the possibility of substantial deferrals of taxation and significantly lower tax rates compared to NSOs. To be qualified as ISOs, stock options must meet several requirements, including the following. First, they must generally be issued only to employees and be exercisable only by the employee during his or her life. Second, they generally must be exercised during the period of employment or within 90 days after the termination of employment. Third, the shares received from the exercise of the ISOs must be held until the later of two years after the grant of the options or one year after their exercise. Fourth, no more than $100,000 in options may vest in any one year (based on the fair market value of the underlying option shares at the time of the grant of the options). And fifth, the exercise price must generally not be less than the fair market value of the underlying shares as of the date the option is granted. Additional restrictions apply to optionees who are holders of 10 percent of voting equity. To illustrate the significant differences between ISOs and NSOs, consider the founder of a company who holds ISOs exercisable at $2 per share and the employee hired later in the company’s life with NSOs exercisable at $10 per share. If the shares are worth $20 and the ISOs and NSOs are exercised on the same day, the founder will pay no tax upon the exercise of the ISO (provided the shares are held for the requisite period), except possibly in connection with applicable alternative minimum taxes as discussed below. The employee, on the other hand, will pay tax on ordinary income equal to the difference between the fair market value of the shares as of the date of exercise and the exercise price, or $10 per share. When the founder holds the ISO shares for the requisite period and later sells them at, say, $30 per share, he or she will recognize income taxable at long-term capital gain rates (currently 20 percent) on the spread between the sale price for the shares obtained through exercise of the ISOs and their exercise price. The maximum ordinary income tax rate, in contrast, is 39.6 percent, although it could be higher depending upon a taxpayer’s individual circumstances. If an option intended to be an ISO fails to meet the ISO criteria, it is treated as an NSO. So, for example, if the founder exercises the ISOs but fails to meet the holding period tests, the taxation applicable to stock acquired through NSOs is applicable upon the exercise of the ISO options. This means that ordinary income tax rates apply to the spread between the sale price of the shares (up to their fair market value on the exercise date) above the exercise price paid for them (with capital gains rates applying to any excess proceeds received). As another example, if more than $100,000 worth of options vest in any one year, then the excess options would be treated as NSOs. From the company’s perspective, it may not deduct any expense for the grant of stock options, whether ISOs or NSOs. For NSOs, the company may deduct the ordinary income recognized when they are exercised and the employee recognizes ordinary income. For an ISO, there is no deduction for the company at any point, unless there is a disqualifying disposition by the holder after the exercise of the option that results in the recognition of ordinary income for the holder. PRACTICAL ISSUES The holding period for ISOs presents a significant practical problem for many employees. A founder may have sufficient resources to exercise options and hold the shares for the period necessary to receive capital gains treatment. When an employee wishes to exercise ISOs, he or she often has to borrow money to do so. In order to repay the loan, employees sometimes are forced to sell the shares, resulting in a disqualifying distribution that triggers ordinary income taxation. Some companies and investment firms offer one-step “cashless exercise” programs for completing such transactions without requiring the employee to incur interest costs. The practical problems most employees would encounter in exercising ISOs and holding the shares may make NSOs the most logical type of option to grant employees. The company also faces a practical problem with non-employee holders of stock. In general, non-employees can only receive NSOs. Employees, however, may receive either ISOs or NSOs while employed and may hold such options or shares received through such options after their employment terminates. If the holder of an ISO exercises the option either before or soon after terminating employment, the company must keep track of the holding period for the shares in order to know whether they were held for the qualifying period. This period might be nearly two years after termination of employment, during which time any disqualifying distribution would result in a deduction for the company. Although the exercise of ISOs does not trigger tax recognition, the difference between the exercise price and the fair market value is a “preference item” under the alternative minimum tax (AMT). The AMT is a tax of 28 percent applied to certain income preference items that may otherwise escape taxation. A taxpayer pays the AMT when the tax on his or her other income is lower than the AMT. There may be many circumstances under which the AMT would apply to those exercising ISOs, including situations in which the value received by a person exercising ISOs is comparable to, or exceeds, the person’s ordinary earnings. Although the taxation of a later sale of the shares is partially offset by any AMT paid, triggering the AMT reduces one of the primary benefits of ISOs — tax deferral. TERMS OF OPTION PLANS Options are typically issued to employees as part of equity compensation plans that qualify for certain exemptions from securities and tax laws. These plans typically include other features and limitations that could be important to an employee. Stock option plans affect the option holders’ rights upon termination of employment. In most cases, ISOs must be exercised within 90 days of termination (subject to extensions for special circumstances, including death and disability). While NSOs may be exercisable beyond 90 days following termination, options plans provide for wide variations in the ability of terminated employees to continue to exercise them. In addition, private companies usually retain the right to require the holder of shares acquired through the exercise of either ISOs or NSOs to sell such shares to the company upon specified terms, even if this “call” constitutes a disqualifying distribution of shares triggering adverse tax consequences for the holder of the shares. The price and terms of such “call” options typically depend upon the reasons for the termination. In general, terminations “for cause” result in less favorable terms for the employee than terminations under other circumstances. The consequences of certain corporate events, such as mergers or issuances of new stock, are also important to option holders. Stock option plans typically provide broad discretion to the company’s board to make certain adjustments to outstanding options to account for changes in the capital structure, such as the issuance of new shares, stock splits or the payment of unusual dividends. Such adjustments may be implemented through adjustments to the exercise price or the number of shares subject to the option in order to maintain the value of outstanding options in relation to new options being granted or in relation to changes in the value of the shares. Although such adjustments are typically discretionary, they cannot be made without provisions in the option plan authorizing them. Similar protections may exist with respect to changes of control affected by the purchase of a controlling interest in the company by a new shareholder. In such events, unvested options may be extinguished or may be deemed vested, depending upon the terms of the plan. In addition, options may be deemed exercised or may expire, depending upon the terms of the plan and the exercise of discretion by the board. This is one of the critical issues from an employee’s perspective, as the purchase or merger of a company accounts for about 80 percent of the dispositions of private technology start-ups, with public offerings accounting for approximately 20 percent. RELATED ISSUES The taxation of stock options and their exercise involves other issues important to management and founders of companies. For example, the form of organization may be affected by option compensation plans. Limited liability companies (LLCs) are companies formed like corporations in which the members are entitled to limitations on liability similar to shareholders of a corporation. They are, however, taxed like partnerships. Such organizations are popular with technology start-ups and frequently issue options for the purchase of membership interests, similar to stock options, as part of incentive compensation plans. The tax consequences of exercising options in an LLC are different than in an ordinary corporation, however, with the tax effects of options and their exercise being passed directly on to other members of the LLC. The exercise of options in connection with LLC membership creates tax liability issues for other members that are difficult to correct after the plan has been implemented and options granted. The accounting treatment of option plans and other forms of equity compensation needs to be considered in connection with the establishment of such programs. Some forms of equity compensation are not reflected as charges against income, while other forms of equity compensation may be. The terms of the specific plans and of the options themselves could affect the accounting treatment accorded the issuance of the options or other equity compensation and the exercise of rights by the holders. Securities law issues also arise in connection with grants of options, their exercise and the transfer of shares obtained through options. In general, grants of such securities from an issuer to employees, officers and directors are exempt from registration if conducted pursuant to a qualified plan, but the issuance of shares, exercise of options and sale of shares require registration or an applicable registration exemption. RESTRICTED STOCK Restricted stock may be an attractive alternative to stock options under some equity compensation plans. Restricted stock is stock that is issued subject to transferability limitations for a certain period and to the forfeiture of rights to the stock upon termination of employment. Restricted stock is ordinarily taxed as ordinary income equal to the value of the stock on the date that the restrictions lapse, and such stock may be freely transferred by the holder. A holder of restricted stock may obtain more favorable tax treatment under �83(b) of the Internal Revenue Code (an “83(b) election”) by making an election within 30 days of receiving such stock. That election requires the payment of tax on the fair market value of the restricted stock upon the date of receipt (less any consideration paid, which is typically none). After the lapse of the transfer restrictions and the sale of the stock, the holder of the shares pays only capital gains taxes (assuming compliance with holding periods) on the excess of the sale price over the original fair market value on which tax was paid at the time of the election. If the stock has a very low initial value and is expected to appreciate, then the 83(b) election may be the least costly way to receive incentive compensation. Compliance with capital gains holding periods is also favorably affected by the 83(b) election. Absent the election, the period for capital gains holding begins on the date that the restrictions on transfer of the stock expire, which is usually a period of years after the stock is initially received. Under the 83(b) election, the capital gains holding period begins upon the date of the election, at or near the time that the stock is received. The primary disadvantage of using restricted stock in equity compensation plans is that if the holder’s employment is terminated, the restricted stock is forfeited. The employee loses whatever value the shares may have attained. If the holder has made the 83(b) election, any taxes paid are also forfeited, usually without the holder having any deduction or credit for the taxes paid upon the value of the shares at the time they were originally received. If the shares had a low value and a small amount of tax was paid, the 83(b) election could be worth the risk. RESTRICTED STOCK v. OPTIONS NSOs and restricted stock are comparable in many respects. The employee’s rights vest over time and are largely terminated upon termination of employment, at least termination for cause. NSOs and restricted stock are ordinarily taxed on the difference between fair market value and purchase or exercise price on the date of exercise or termination of the restrictions on transfer, in the case of restricted stock. Restricted stock, however, offers the advantage of significantly reducing the long-term tax liability if the holder elects ordinary income treatment when the stock is received. In order to obtain comparable tax benefits with ISOs, an employee has to have the means to purchase the shares at the time of exercising the options and to hold the shares for the required period. Even if the holding requirements are met, the other technical requirements limit the flexibility of ISOs significantly. For these reasons, restricted stock may offer significant advantages to employees as a form of equity compensation. Robert F. Lawrence is a partner in Milbank, Tweed, Hadley & McCloy, where he divides his time between the New York and Washington, D.C. offices and is involved in the firm’s technology finance practice serving Northern Virginia. Troy Ficarra, an associate in the tax and employee benefits practice in Milbank’s New York office, assisted in the preparation of this article.

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