The point of paying employees anything is to give them an incentive to show up for work and give you their best effort. There are many different forms of compensation. Employee compensation often includes basic salary, bonus, health insurance coverage, fringe benefits and retirement plan contributions. All are important. But if you really want to get your employees thinking like business owners, you may want to consider letting them acquire an ownership stake.
One way to do this is to give your most valuable employees a stock option. When an employer gives an employee a stock option, the option agreement should state the number of shares subject to the option, the option price per share, the period of time during which the option may be exercised, applicable transfer restrictions and any other appropriate provisions or restrictions.
Stock options generally come in two basic forms. One type of stock option is called an Incentive Stock Option (“ISO”). The other type of stock option is referred to as a Non-Qualified Stock Option (“NQSO”). An ISO is entitled to special treatment under federal and state tax law and must comply with the requirements of such law. One of the federal income tax requirements of an ISO is that the option price must be equal to 100% of fair market value at the time the option is granted. For federal and state income tax purposes, the employee does not recognize any compensation income, and the employer gets no compensation deduction, either at the time the ISO is granted or at the time the option is exercised. Rather the employee recognizes a capital gain (or loss) at such time as the stock received upon option exercise is sold.
A NQSO is treated differently than an ISO for federal and state income tax purposes. The employee recognizes compensation income, and the employer gets a compensation deduction, at the time the option is exercised. The amount of the compensation income recognized by the employee (and the amount of deduction taken by the employer) is equal to the excess of the value of the stock on the date of exercise over the exercise price. When the stock acquired upon option exercise is sold, the employee will have a capital gain (or loss).
More about stock options, restricted stock awards, phantom stock and other employee compensation and incentive arrangements will be found in a future blog post. If I can help you set up an incentive or non-qualified stock option plan for your management employees, let me know. Jsenney@pselaw.com or 937-223-1130
AND ONE MORE THING. Have you ever heard of a DISC? Does your business have significant foreign sales or income? Does your business sell to other companies that export the final product? You can reduce the federal income tax rate on such income significantly by setting up a DISC. Give me a call or email me and ask me how at Jsenney@pselaw.com or 937-223-1130.