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TAX CONSEQUENCES—NONQUALIFIED STOCK OPTIONS What Are the Tax Consequences for Employees?
When employees exercise a NQSO, they recognize compensation income equal to the difference in the exercise price and the market price at the time of exercise (the spread).
Using the same example:
(25 - 0.10) x 10,000 = $249,000 of compensation income will be reported
What Are the Tax Consequences for the Employer?
The employer will have a tax deduction for the compensation income recognized by the employee. The employer will pay payroll employer taxes on the compensation (FICA, Medicare, federal and state unemployment taxes), and these taxes are deductible by the employer.
Independent contractors can receive NQSOs. In that case, they receive a 1099 for the spread (the difference between the option price and the fair market value).
Nonqualified Stock Options That Vest When the Business Is Sold
An effective approach in small business is to use NQSOs that vest on the sale of the business. This allows the employer to
Tax Consequences—Nonqualified Stock Options 77
Table 6.24 Highlights of Stock Option Program
Attracts employees Loss of ownership control
Motivates employees Complex tax issues
Low up-front cost No current tax deduction
NQSOs vest on sale of business Risk of unwanted shareholders
retain control of the business and still motivate employees, who will share in the growth of the business when it is sold (see Table 6.24).
Stock-based compensation has benefits, including the ability to attract and motivate employees at relatively low upfront cost. Still, it is important to recognize the complex tax issues as well as the risks of having minority shareholders in terms of losing ownership and control your business. Further, the employer does not receive a current tax deduction (current tax savings) from stock options. An effective use of stock options for a small business is to have them vest on the sale of the business.
If you do not want to share stock ownership with employees, consider a deferred compensation plan.
Nonqualified Deferred Compensation Plans
With nonqualified deferred compensation plans, you can put more money away and select whom you will cover. Nonqualified plans can focus exclusively on the business owner and/or key employees (and exclude most employees). Nonqualified plans can be implemented in addition to qualified plans (see Table 6.25).
What Are the Options?
Table 6.25 Options Framework by Complexity and Cost of Administration
Easy/Inexpensive More Complicated/Costly Complex/Expensive
Bonus Defined contribution Stock options
SEP 401(k) Nonqualified plans
SIMPLE Defined benefit ESOP
Owners and employees who want to defer more income than is allowed under qualified plans such as the 401(k) can consider a plan in which a portion of the employee’s current salary is deferred and the employer promises to pay that amount in the future. To avoid paying income tax currently, the employee must not have “constructive receipt” or the ability to access and control the funds. To avoid current taxation, there must be a substantial risk of forfeiture. The goal is to delay paying the income until the employee is in a lower tax bracket, usually in retirement. The business owner does not receive a deduction for the deferred compensation until the employee recognizes the income.
With nonqualified deferred compensation plans, there are no required vesting schedules and there must be forfeiture provisions to obtain tax deferral. Forfeiture provisions mean that employees have a substantial risk of losing the deferred compensation. Examples of forfeiture provisions include leaving the company, working for a competitor, conviction of a crime, or loss of license.
Forfeiture provisions are effective in retaining key employees. Forfeiture provisions also mean the employer does not have to pay employees who leave the company.
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Funded or Unfunded Plan?
With a funded plan, the employer transfers the deferred compensation money to an irrevocable trust. This assures that the funds are set aside to pay the deferred compensation and are protected from claims of creditors of the company. The risk with a funded plan is that the IRS may decide that the funds have become substantially vested and the income will be taxable to the employee currently.
In unfunded plans, the employer has access to the deferred compensation funds, and they are subject to the claims of creditors. The risk is that the funds will not be available when the employee retires. Life insurance can be used as an informal funding mechanism to assure the employee that the funds will be there in the event of the employee’s death.
The Internal Revenue Service scrutinizes these plans. The IRS can find that deferred compensation payment for the owner is really a “disguised dividend” and should be taxable currently. Further, the IRS may find that the substantial risk of forfeiture is not credible and hence the funds should be taxable as current income (see Table 6.26).