Equity Compensation – The Ups and Downs of ISOs"

CFO Corner: Equity Compensation – The Ups and Downs of ISOs

By
now most compensation professionals know that stock options are a tool
with
built-in cost (usually the stock price on the grant date) for the
participant.
They are almost always subject to vesting schedules and are powerful
tools that may be very beneficial when conditions are right, but
dangerous
if used incorrectly.

ISOs
are a special kind of stock option. They were created to provide income and tax
advantages. IRC 421, 422, 423 and 424 provide a rule set for ISOs other forms
of tax-qualified equity. ISOs are defined mainly in IRC 422. So, what makes
ISOs so special?

1. ISOs offer
   the ability to exercise options without an immediate income event.


2. They allow
   individuals the potential to avoid ordinary income and associated taxes
   altogether.


3. They require
   no Medicare or Social Security taxation and withholding (or the matching
   company payment.

ISOs
require specific plan provisions and grants must adhere to a restrictive rule
set. The plan may only allow for new ISO grants for a period of 10 years. The
plans must also specify the aggregate number of shares that can be granted as
ISOs. The grants cannot be priced below the Fair Market Value on the grant date
(and 100% of the FMV for individuals who own 10% or more of the company.) They
can only be granted to employees (full or part-time.) The grants must expire in
no more than 10 years (5 years for the 10% shareholders.) The value of ISOs for
an individual cannot exceed $100,000 in exercisable ISOs in any calendar year.
In order to obtain the preferential tax treatment, exercised shares must be
held for at least two years from the date and grant and 1 year from the date of
exercise (if these periods are met then the eventual gain is treated as capital
gain/loss rather than ordinary income). That’s enough boring rules for now….

Even
with these restrictions most employees would much rather receive ISOs than
NQSOs. The benefits outweigh the downsides. And, there are significant
downsides to both the individual and the company.

1. The spread
   at the time of exercise is an AMTI preference item, meaning that an individual
   may owe tax on ISOs they have held for the holding period benefit.


2. Unlike NQSOs
   where it is guaranteed, the company cannot plan ahead in expectation of the
   corporate tax deduction that comes with ordinary income.


3. ISOs, like
   any appreciation instrument, may not have exercisable value when they finally
   vest. The stock price must be higher than it was at grant.

ISOs
are most commonly seen in pre-IPO start-ups where the potential of stock price
increases are high (as long as the company is successful) and the gains are
large enough to make holding the stock for capital gain treatment
enticing.  They are still very common for
executive compensation programs. Executives generally have the investment
knowledge and advice required to make good decisions about the somewhat complex
tax planning opportunities. One place they have melted is in broad-based
programs at small and midsized public companies. This is mainly due to the fact
that few employees take advantage of the ISO upsides while all companies are
hit but the ISO downsides.

Incentive
Stock Options are an incredibly useful tool in your compensation toolbox. Proper
plan design, education and planning can reduce most of the negatives, while
augmenting the positives. They are not a cure-all or silver bullet, but used
intelligently can provide an impact that cannot be attained with any
other type of compensation.

This
post is part of a series of posts on equity compensation instruments that will
run the first Thursday of every month for the foreseeable future.  As always, you can reach out to me directly.

Dan Walter is the President and CEO of Performensation an
independent compensation consultant focused on the needs of small and mid-sized
public and private companies. Dan’s unique perspective and expertise includes
equity compensation, executive compensation, performance-based pay and talent management
issues. Dan is a co-author of “The Decision Makers Guide to Equity Compensation”, “If I’d Only Know That”, “GEOnomics 2011” and “Equity Alternatives.”
Dan is on the board of the National Center for Employee Ownership, a partner in the ShareComp virtual conferences and the founder of Equity Compensation Experts, a free networking group. Dan is frequently requested as a
dynamic and humorous speaker covering compensation and motivation topics.
Connect with him on LinkedIn or follow
him on Twitter at @Performensation and @SayOnPay