Considering Equity-Based Compensation? Learn the Tax Considerations

Equity-based compensation is a tool used to attract and retain top talent. There are several ways equity is typically issued as compensation:

• Stock options
  • Incentive stock options (ISOs) — issued to employees
  • Non-qualified stock options (NQOs) — issued to non-employee directors and consultants or to employees in lieu of ISOs
• Restricted Stock Awards (RSAs) — issued to employees, directors, or consultants

While these vehicles may have similar attributes to profits units, this blog doesn’t address those reporting and tax considerations. Look for a future blog on this topic.

Tax considerations in equity-based compensation

The tax treatment of equity-based compensation depends on the award type. In theory, stock options are generally taxed when exercised, while restricted stock is taxed when vested. In practice, however, there are common structures which may help recipients reduce tax exposure on these incentive grants.

Incentive stock options

With ISOs, if the exercise price on the option is equal to the fair value of the stock at the grant date and the other requirements of IRC 422 are met, these types of grants allow recipients to defer paying tax until the option has been exercised and the underlying equity has been sold, thus deferring any tax on the recipient until they receive sale proceeds. In addition, there is an opportunity for gains to be taxed at capital rates. If the exercise price is less than the market value when exercised, however, there is a risk the discount could trigger the alternative minimum tax (AMT) when the stock is exercised and result in paying taxes prior to disposing of the equity.

NQOs must be taxed upon exercise. The tax is calculated as the excess of the fair value over the aggregate exercise price.

Restricted stock awards

In the case of RSAs, recipients recognize taxable income in the year of vesting. The amount of the income is equal to the fair market value of the underlying stock on the vesting date. Alternatively, recipients of RSAs may elect to be taxed earlier, in the year of grant (and based on the fair market value at grant), even though the property remains unvested. This is called an 83(b) election. Although not without risk, an 83(b) election may result in a lower overall income tax obligation when the stock underlying the RSA has a low value on the grant date, such as stock in an early-stage start-up or a junior class of stock. Employees can take advantage of this election by filing a written statement with the IRS and their employer within 30 days of the grant.

The company is responsible for reporting accurate compensation information to the IRS for awards and exercises on employees’ W-2 each year. When an employee exercises NQOs or recognizes income from RSAs, the company is required to withhold income and employment taxes on the taxable income component and remit the withheld taxes to the appropriate tax authorities.

Reporting considerations in equity-based compensation

In addition to tax considerations, private companies must accurately account for equity-based compensation in their GAAP basis financial statements. 

The fair value of the equity award must be estimated at the date of grant and generally then be recognized as an expense over the vesting period. In the case of performance-based vesting conditions, management must make assumptions about the amount and timing of vesting. This typically involves running probability-based scenarios to determine the initial fair value of the equity award and a compensation expense attribution schedule. Companies must then assess and adjust these estimates at each reporting period for changes in these assumptions and/or actual results.

In addition, the subsequent accounting after the date of grant requires a sometimes-complicated assessment of the settlement provisions of the equity award to determine if the equity award meets the criteria to be accounted for as an equity-classified award or, alternatively, as a liability-classified award. The classification of an equity award is not an accounting policy election, rather it’s a determination based on the specific terms and conditions of the award. A liability-classified award differs from an equity-classified award, which is generally measured at fair value on the date of grant and would only be updated if modifying the award, in that a liability-classified award is required to remeasured to an updated fair value at each reporting date until the award is settled.

Companies are required to disclose information such as the amount of vested and unvested awards at each period, their weighted average fair values and strike prices, and the resulting compensation expense within each reporting period in the financial statement notes.

Determining the fair value of equity-based compensation

The fair value of equity-based compensation at the grant date is a key component for both tax and accounting purposes. There are several methods companies can use to determine the fair value of equity-based compensation, for particular purposes, including:

• Market approach — Uses the market price of similar equity instruments.
• Income approach — Uses the present value of expected future cash flows.
• Option pricing models — Uses option pricing models, such as the Black-Scholes model.

For private companies which cannot rely on a quoted price in the market, this can be a difficult exercise. For this reason, many companies engage a third party to prepare a valuation to satisfy the IRS and independent auditors.

In the case of stock options, a more robust independent appraisal, commonly referred to as a 409A valuation, is used to establish fair market value and provide comfort against a stock valuation challenge.

Modifications of equity awards

One last important area to keep in mind is modifications of equity awards after they are granted. In general, financial reporting regulations treat these as an exchange of assets at the modification date. Upon modification, the company is responsible for determining the award value being modified under its original terms and then determining a new award value under its modified terms. This will trigger another round of valuation and reporting exercises.

For tax purposes, the modification of an equity award is treated as a new option grant unless certain specific rules are met. This can result in unexpected (and sometimes unintended) tax consequences for both the company and employees.

How CLA can help with equity-based compensation

CLA can help with:

• Technical accounting — CLA has decades of experience in this area. We can assist with a detailed assessment of the appropriate accounting treatment based on the specific terms and conditions of the equity awards, as well as setting up policies and procedures for accounting for equity-based compensation and GAAP-based reporting.
• Tax planning — CLA’s tax professionals can help you understand and address IRS rules for reporting, withholding, and remitting taxes on equity-based compensation. We can also advise on plan design and review documents for unintended tax consequences.
• Valuation — CLA can prepare the valuations required by the IRS and for GAAP reporting.

Considering an equity-based program? Contact us for assistance.