Start-up and public companies increasingly utilize stock options to compensate key personnel. This is particularly true for technology companies, which typically have made use of stock options as a significant component of executive compensation. Such options improve productivity by providing employees with a stake in the business and often permit employers to provide attractive compensation packages without adversely affecting earnings or cash flow.
Unfortunately, nonqualified stock option plans carry with them adverse tax treatment on exercise. The spread between the exercise price and the value of the stock at exercise, assuming the stock is then vested, is subject to tax at ordinary income tax rates. The tax on exercise often forces the executive to sell shares, which is inconsistent with the employer's desire for key personnel to have a substantial stake in the success of the business. To avoid a charge to earnings because of certain accounting rules, most employers would not be willing to extend the option exercise period.
One technique to address this problem involves a deferral of the stock option gain. Instead of receiving shares on exercise, the employee enters into a deferral agreement with the employer which gives the employee the right to receive the shares at a future date or on termination of employment. Earnings attributable to the shares (i.e., dividends) are generally reinvested in additional deferred shares. Alternatively, dividends could be paid to the employee on a current basis or paid in cash with interest on a deferred basis. Deferred shares are sometimes deposited into a "rabbi trust" to provide employees with a measure of security. However, employees entitled to deferred shares are general creditors of their employer, even with such a trust.
To avoid "constructive receipt" problems, there should be a reasonable interval between the time of the deferral election and the time the option is exercised. Although there are no hard-and-fast rules here, and no specific guidance from the Internal Revenue Service, a six-month interval is commonly used and is considered by many practitioners to be sufficient.
The primary benefit of this technique is that income tax is deferred until the end of the deferral period. A potential disadvantage is that taxable income is measured based on the difference between the exercise price and the value at the end of the deferral period. This has the effect of converting post-exercise appreciation from capital gain to ordinary income.
Exposure to employment tax is not deferred by an arrangement such as this. At the time an option is exercised, even though receipt of the shares is deferred, the spread between the exercise price and the value of the stock at exercise is treated as "wages" for FICA purposes.
The option deferral technique is particularly beneficial when options are exercised with previously-held shares. To avoid accounting issues, such shares must have been held for at least six months prior to exercise of the stock option.
A deferral plan should be designed to be exempt from the requirements of the Employee Retirement Income Security Act of 1974 as to participation, vesting, funding and fiduciary responsibility. Such an exemption will require that participation in the plan be limited to a "select group of management or highly compensated employees."
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