Weighing Your Options…

By Jason Weiszhaar

Every small business has been there. Your best employee asks for a raise, but you have limited cash flow available to support an increase. Do you find a way to cut costs elsewhere in order to placate your employee, or is there another option available?

For many small businesses today, the answer is found by providing equity awards, specifically restricted stock and stock options. Large companies have used these vehicles as a means of attracting and retaining quality employees for years and more and smaller companies are finding such awards can both reward employees for their contribution and performance, and foster a sense of partnership and commitment from them.

A Few Characteristics about Restricted Shares and Options

Often, shares and options issued to employees are restricted in some manner andvest over a period of time,or when certain performance goals are met. In addition, they may not be able to be sold until they are vested, or in some instances, until the business is sold ora liquidity event occurs (e.g. a public offering). While restricted stock can offer immediate ownership interest in the business, stock option grants represent the right to acquire ownership shares for a certain period of time at a specified price that is typically fixed on the grant date. The receipt of a stock option may not be as attractive as receipt of restricted stock to an employee because of the cost involved and because the options would be worthless if the value of the company’s shares fall below the employee’s strike price (unlike a stock grant which is generally granted at no cost).

Tax and Financial Statement Implications

Since the Internal Revenue Code is more than seven times the length of the Bible, I am sure it will not surprise you to know that the tax treatment of restricted stock and stock option awards is different, and that this article is not designed to discuss all of the taxramifications (including potential alternative minimum tax considerations) of equity based awards (or for that matter the impact of such awards on your financial statements).

Notwithstanding that, stock and option grants generally result in some amount of expense being recorded for financial statement purposes. In the case of stock options, the expense is normally equal to the value of the shares issued on the grant date, although some discounts may be applied for such things as lack of control and marketability. For tax purposes, on the other hand, the amount and timing of deductible expenses for a company depends on when the employee actually recognizes taxable income from the shares. Under current regulations, employees may choose to recognize income immediately upon the date the stock is granted in an amount equal to the stock’s value on that date by filing a Section 83(b) election for income tax purposes. If this election is made, there would be no difference between the company’s deduction and the income recognized by the employee for the shares. If the election is not made, however, the recipient would recognize income on the dateany restrictions lapse in an amount equal to the value of the stock on that date and the company will obtain a tax deduction at that time.

Financial statement expense recognition for stockoptions is generally based on estimated values of the options using an accepted option valuation model (e.g. Black-Scholes). Like restricted stock that contains vesting provisions, thefinancial statement expense is generally recognized over the service period, which may be the vesting period or estimated time to reach a performance measure depending upon the nature of the options. For tax purposes, however, treatment depends on whether the options are considered nonqualified stock options (NSOs)or incentive stock options (ISOs).

Unless an option meets the requirements of Internal Revenue Code, SEC 422 for a qualifying incentive stock option plan, they are considered NSOs. Tax deductions for NSOs are limited to the amount of income recognized by the employee upon exercise of the option, which may be more or less than the amount expensed for financial statement purposes.For ISOs, the company does not receive a deduction for issuance of the options, but the employee will be entitled to recognize income upon exercise at favorable capital gains rates.

Weigh the Options…

While this may initially seem like a panacea for all concerned, the decision to grant equity based awards should not be made lightly given some of the potential pitfalls, a couple of which are highlighted below.

• Equity grants can be expensive. The old bromide that “a rate commensurate with the risk involved” may apply becauseif your company is experiencing significant growth in earnings and/or market share the cost of issuing equity instruments can potentially be much greater than the cost of borrowing to provide raises.

• Equity grants can result in additional responsibilities on your part. It is important to remember that generally your fiduciary responsibility to an “owner” is much higher than it would be for an employee. Because of this you should strongly consider consulting with legal counsel before you issue any equity awards.

Notwithstanding the above,equity ownership by employees can still be a great way to reward your key employees and obtain their “buy-in” and commitment. A careful consideration of the benefits, drawbacks and tax effects of the different equity plans may show that you can compensate people in a way that increases loyalty and incentives while saving you cash. Give those employees a stake in the future success of the business and you will have everyone pulling together to move your company forward. So the next time an employee comes to you asking for a raise, sit them down and say, “Let’s weigh the options…”

About the Author
Jason Weiszhaar is an Audit Senior with Kingery & Crouse, PA in Tampa, FL. Kingery & Crouse, P.A. is a full service public accounting firm with a staff of dedicated professionals providing audit (including SEC and employee benefit plan audits), tax and accounting services. You may contact Kingery & Crouse at (813) 874-1280 or find us on the web @ www.tampacpa.com.