Equity-based compensationTypical forms
What are the prevalent forms of equity compensation awards in your jurisdiction? What is a typical vesting period? Must the arrangements be offered to a broad group of employees, or can the employer select the participants?
As discussed in question 9, common forms of equity compensation for corporations are stock options, SARs, restricted stock, RSUs, and PSUs, each of which may be subject to time-based or performance-based vesting. Partnerships and limited liability companies taxed as partnerships typically grant profits interests. Common vesting schedules for stock options and SARs provide for annual, graded, vesting over a period of three to four years. The typical vesting period for restricted stock, RSUs and PSUs is three to five years, usually in annual instalments, although performance-based awards typically provide for cliff vesting at the end of a performance period (with three years being a very common performance period). Performance-based conditions (which most often are also accompanied by continued employment conditions) vary greatly depending on the company’s business and shareholder concerns. Financial measures and relative total shareholder return are most common. The vesting periods and conditions for profits interests vary widely, but it is common for such interests to require continued employment through a ‘liquidity’ or ‘exit’ event or repurchase upon termination of employment prior to a liquidity or exit event pursuant to a formula that takes into account the reason for termination (eg, ‘good leaver’ or ‘bad leaver’ provisions).
Must equity-based compensation be granted by the company’s board of directors (or its committee) or can the authority be delegated to officers or employees of the company? Are there limitations or requirements that apply to delegation?
The law of the state of incorporation of a corporation will determine whether the board directors or a committee thereof must grant equity awards. Generally, however, the authority to grant actual equity (as opposed to the right to receive equity, such as stock options and RSUs) must be granted by the company’s board or a committee thereof. In addition, it is almost always the case that the board or a committee thereof, as a matter of corporate governance, will retain the authority to grant all equity and equity-based awards. The board or committee, as applicable, may delegate the authority to grant equity or equity-based awards provided that the right to grant actual equity must typically be granted to a ‘subcommittee’ of the board, for example, the CEO of the company who is also a member of the board. Any delegation must include limitations on the amount of equity that can be granted by the delegate, including, at a minimum, the value of the equity or equity-based awards that can be granted within a specified period of time. Sometimes, the delegation of authority will also include restrictions on the timing of grants subject to the delegation or limitations on the types of awards that can be made pursuant to the delegation.Tax treatment
Are there forms of equity compensation that are tax-advantageous or disadvantageous to employees or employers?
Restricted stock awards give the employee the ability to elect, by filing an election under Code section 83(b), to recognise ordinary income at the time the award is granted in an amount equal to the value of the award on the date of grant and to receive capital gains tax treatment on any appreciation. This can provide a benefit because capital gains tax rates are lower than the rates for ordinary income (and capital gains are not subject to withholding taxes). It does, however, present some risk to the employee due to the risk of forfeiture of the stock after the tax has been paid; whether the loss can be recouped depends on the individual’s personal tax situation.
Statutory options (typically referred to as ‘incentive stock options’ or ‘ISOs’) are eligible for special tax treatment. In order to qualify as an ISO, an option must satisfy the requirements of Code section 422. ISOs are not subject to tax upon grant or exercise and, provided the employee satisfies the holding requirements for the underlying stock, the difference between the amount realised upon the disposition of the shares and the amount paid for the shares will be treated as long-term capital gain (or loss, if applicable). If the holding period requirements are not satisfied (ie if there is a ‘disqualifying disposition’ of the shares, the employee generally will recognise ordinary income (for regular income tax purposes only) in the year of the disqualifying disposition equal to the excess, if any, of the fair market value of the shares on the date of exercise over the exercise price. Any excess of the amount realised on the disposition over the fair market value on the date of exercise will be taxed as long- or short-term capital gain (as applicable). If, however, the fair market value of the shares on the date of disqualifying disposition is less than on the date of exercise, the employee will recognise ordinary income equal only to the difference between the amount realised on the disqualifying disposition and the exercise price.
Code section 423 permits an employer to establish an ESPP that permits employees to purchase employer stock at a discount of up to 15 per cent of the fair market value of the stock and to receive favourable tax treatment on such purchases.
An employer should always consider the accounting treatment of equity awards that are being granted. The accounting treatment can vary significantly, positively or negatively, depending on the type of award and the structure of the award (eg, the vesting provisions and whether the award can be settled in cash rather than stock at the election of the company).Registration
Does equity-based compensation require registration or notice? Are exemptions, or simplified or expedited procedures available?
In a public company, the shares issued in connection with equity-based compensation must be registered unless an exemption from registration is available. The most common way to register shares under an equity-compensation plan is to use a Form S-8. Form S-8 is required to include a prospectus that outlines the material terms of the plan pursuant to which the shares are being offered, including the tax treatment of awards. The prospectus does not need to be publicly filed with Form S-8 but it is required to be provided to award recipients. Because of the absence of a filing requirement, preparation and distribution of a formal prospectus is sometimes overlooked.
In addition to Form S-8, shares issued in connection with equity-based compensation can be registered on other forms, including Form S-1 and Form S-3. These forms are significantly more complex than Form S-8 and are not designed for equity plan registration but rather general securities registration. Accordingly, they are rarely used to register equity-based compensation awards except in unusual circumstances.
There are certain exemptions from registration that might apply in certain circumstances. Common exemptions include:
- plans not subject to certain reporting requirements of the federal securities laws (Rule 701);
- sales to accredited investors (Regulation D); and
- private placements (section 4(a)(2) of the Securities Act).
State securities laws (called ‘blue sky laws’) are designed to protect investors from fraud and may require registration by non-public companies. Each state has different laws and a company must ensure compliance with the laws of each state in which it is offering securities as compensation.Withholding tax
Are there tax withholding requirements for equity-based awards?
Income and employment tax (Federal Insurance Contributions Act (FICA) and the Federal Unemployment Tax Act (FUTA)) withholding applies to most equity-based awards to employees. Withholding is not generally required for awards to service providers other than employees, such as awards to directors or independent contractors. Some states, however, do require withholding of state income tax on compensation payable to directors, including non-employee directors. The employer has the obligation to withhold the applicable taxes and pay them to the IRS or the applicable state tax authority.
Generally, the withholding obligation for income taxes arises when income is paid to the individual. For example, in the case of a nonqualified stock option, the individual recognises income upon exercise of the option and that is when the withholding is required. Similarly, in the case of restricted stock units, the income is recognised (and taxes due) upon settlement of the RSUs. Restricted stock is generally taxed when it becomes vested unless the employee files an election under Code section 83(b) to be taxed on grant and, in that case, the income is recognised and the withholding is due at the time of grant.
Normally, the withholding obligation for employment tax arises at the same time as the income tax withholding obligation. In the case of deferred compensation, however, Code section 3121(v) provides that such compensation is taken into account for FICA tax purposes at the time it becomes vested and the obligation to withhold generally arises at the same time. Thus, withholding for FICA taxes may be required prior to payment of the underlying deferred compensation, in which case the employer would need to make arrangements for the withholding to be satisfied at the proper time. For example, employment taxes could be withheld from other compensation payable to the employee, or the equity plan or award could provide for a distribution in an amount sufficient to satisfy the applicable withholding obligation (plus any income taxes on the amount distributed).
A company also needs to ensure that its withholding obligations are satisfied even when the payment or settlement of an award is in the form of stock, as is common in the case of equity and equity-based awards. The most common approach is to provide for the withholding to be satisfied from the shares that would otherwise be delivered to the participant upon vesting or settlement of the award (‘net withholding’). The employer could also require the employee to pay the withholding taxes, or taxes could be withheld from other income payable to the employee.
State income taxes are generally governed by the law of the state in which the services were performed that give rise to the compensation. Although withholding is generally required, state laws vary significantly as to what type of compensation is taxable and/or subject to withholding and applicable state laws need to be reviewed based on the specific facts of each case.Inter-company chargeback
Are inter-company chargeback agreements between a non-local parent company and local affiliate common? What issues arise?
Inter-company chargeback agreements for compensation are common between a parent and its affiliates when employees are employed by one entity in the group for tax purposes (eg, are paid on one company’s payroll) but provide services to other entities in the group. These agreements take varying forms depending on the compensation and employment structure of the group of companies but they generally cover tax and accounting issues relating to the arrangement. Specific issues that are frequently addressed include what is to be charged back to other companies in the group, when the chargeback is made, how much is charged back, allocations of tax deductions to each company in the group (assuming that the tax returns are not consolidated) and, if applicable, how to determine how the value of the compensation will be treated (eg, whether it will be treated as a contribution to capital from a parent to the affiliate or a dividend from an affiliate to the parent or in some other manner).Stock purchase plans
Are employee stock purchase plans prevalent or available? If so, are there any frequently encountered issues with such arrangements?
As discussed in question 19, Code section 423 permits an employer to establish an ESPP that permits employees to purchase employer stock at a discount of up to 15 per cent of the fair market value of the stock and to receive favourable tax treatment on such purchases. Code section 423 imposes many requirements on such plans. Although many companies have established ESPPs, the numerous requirements that must be met have deterred others from establishing these types of arrangements. In addition, as outlined in the next paragraph, the Code section 423 requirements preclude ESPP designs that limit eligibility to only certain segments of an employer’s workforce, and preclude many companies from establishing ESPPs altogether on account of the structure of the company’s business.
Some of the frequently encountered issues with ESPPs that are intended to satisfy the requirements of Code section 423 include the following:
- awards under the ESPP can only be granted to employees of a corporation or a direct corporate subsidiary of the issuing company;
- employees of partnerships cannot participate in the ESPP;
- with very limited exceptions, all employees of a company that establishes or participates in an ESPP must be eligible to participate in the ESPP for an offering period under the plan (and impermissible exclusion of even one employee can cause the benefits of the plan to be lost for all participants);
- all employees participating in the ESPP must have the same rights and privileges; and
- the ESPP must be approved by the issuing company’s shareholders (and any changes in the material terms thereof require new shareholder approval).
Permitted exclusions for groups of employees, including employees outside the United States, are limited.
Not all employee stock purchase plans are intended to satisfy the requirements of Code section 423. If an employee is given the right to purchase an employer’s stock at a discount, the right would be treated as a stock option with an exercise price that is below fair market value on the date of grant. If the grant is outside an ESPP that conforms to the Code section 423 requirements, the discounted stock option is subject to the rules of Code section 409A. Care needs to be taken to structure such awards so as to satisfy the requirements of Code section 409A. ESPPs that meet the requirements of Code section 423 are outside the scope of Code section 409A.