Paying People With Stock

Here’s what you need to know about paying people with stock:

Stock-Based Compensation For Services

You can use the stock in your company instead of cash to pay for things that you might otherwise have had to pay for in cash. One way to do this is to pay people for their services in stock rather than cash.

You can pay yourself, your employees and others with stock rather than cash for services in several ways:

  • Stock Grants
  • Stock Options

Although this has the advantage of preserving your company’s cash, it may have unintended or unknown consequences both to your company and to the recipient of stock-based compensation. Make sure you fully understand these consequences before you use your stock as an alternative to cash for compensation purposes.

Stock Grants

You can pay people for services by giving them stock in your company. The stock may be awarded outright, with no restriction, or with restrictions.

Restrictions include:

  • Vesting – The stock is not “vested,” or owned by the recipient until the occurrence of some future event.
  • Forfeiture – The stock is “forfeited,” or returned to the company or subject to repurchase by the company upon the occurrence or non-occurrence of some event in the future.
  • Lock-Up Agreement – An agreement that the recipient will not sell the stock received for a specified period of time that sometimes includes other limiting conditions.

Beware of the Financial Consequences to the Recipient

The IRS treats payments in stock as the equivalent of payments in cash. This means that you must report income and pay tax if you receive stock just the same way as you report income and pay tax if you receive cash.

Here is a typical dialogue between the recipient of stock compensation and their tax adviser:

“You cannot be serious. If I take stock instead of cash as compensation, I have to pay income tax?” YES.

“When do I have to pay the tax?” DEPENDS. Was the stock is given to you outright or with conditions?

“Do you mean that if my company gives me stock with no conditions, I have to report income and pay taxes right away, when I receive the stock?” YES.

“How much income do I have to report and pay taxes on?” An amount equal to the FAIR MARKET VALUE of the stock.

“How do I know what the IRS will call the fair market value of the stock?”

Starting point:

  • If your stock trades – TRADING PRICE.
  • If you stock doesn’t trade – RECENT CASH SALES PRICES.

Potential reductions:

  • You may be able to argue to the IRS that the Starting Point value is not the real fair market value. You may be able to justify reducing, but not completely eliminating, the amount of income you have to report by citing factors such as the restricted nature of the stock, the illiquidity of the trading market, or the fact that your stock is subject to a lock-up agreement. This analysis requires input from your tax adviser.

“Can I eliminate this tax headache if the stock is given to me with conditions?” NO. Conditions may delay the date on which you must report income and pay tax, but do not eliminate tax consequences. But beware of the hidden trap.

If the stock is not “vested,” or owned by you until the occurrence of some future event, you will owe the tax when the event occurs and the ownership is vested.

If the stock is subject to a right of forfeiture and must be returned to the company or may be repurchased by the company upon the occurrence or non-occurrence of some event in the future, you will owe the tax on the date that the event occurs or doesn’t occur, making the stock fully vested.

“But the fair market value of the stock, the amount that determines how much income I report and have to pay, may be greater at the date of these future events than when the stock was granted to me. Does this mean I would have to report income and pay tax at the future higher amount?” YES

“If I receive a stock as compensation with conditions but think the price will go up, subjecting me to higher tax when the Taxing Date occurs, can I elect to pay report the income and pay the tax when I get the stock rather than later when the conditions go away and the stock vests?” YES. By making what the IRS calls a Section 83(b) election. Remember, however, this doesn’t mean you pay no tax. It just means you pay tax today, based upon today’s value of the stock, rather than in the future, at the future value of the stock.

“What if I cannot sell the stock when I get it or when it is fully vested? Do I still have to report income and pay tax?” YES. Although, as noted above, you may be able to use this fact in reducing, but not eliminating, the value of the stock you received.

“This doesn’t seem fair. I get the stock and my ownership is fully vested.. I cannot sell some or all of the stock at that time. I cannot generate cash to pay the taxes but I still have to pay the tax anyway?” YES. Life is not always fair.

Beware of the Financial Consequences to Your Company

Your company has to record as an expense on its financial statements an amount equal to the fair market value of the stock paid as compensation.

Here is a typical dialogue between the recipient of stock compensation and their tax adviser:

“Do you mean I have to record on my financial statement an expense if I issue stock as compensation just the way I have to record cash compensation as an expense?” YES.

“Wait a minute. Could this significantly reduce or eliminate all of my reported earnings?” YES.

“I understand that the recipients can sometimes reduce the amount of income they report on stock grants for things like restrictions or other factors that limit liquidity. Can I do that on my financial statements? NO, in most circumstances.

“This doesn’t seem fair. If I pay people with stock instead of cash, all my earnings could be completely wiped out on my financial statements?” YES. Life is not always fair.

Stock Options

With a stock option, you do not receive the stock right away, as with stock grants discussed above, but rather the right, or option, to acquire the stock in the future on certain specified price or terms.

Stock options do not eliminate the tax problems of using stock for compensation discussed above. Stock options merely delay the date of reckoning, the day you report income and pay tax. Depending upon how the stock option is structured, this date of reckoning may be:

The date you receive the option

A stock option granted with an exercise price below the fair market value of the company’s stock on the grant date (including through an inaccurate stock valuation) could result in significant federal income tax consequences for the option holder as the option vests. An option subject to Section 409A will give rise to recognition of income by the option holder as the option vests (rather than at the time of exercise), plus an additional 20% tax.

The date you exercise the option

If the option is not granted under a specifically qualified plan, as discussed below, the option is called a “Non-Qualified Stock Option” and you report income an pay tax based upon the difference between the price you pay for the stock under the option and the fair market value of the stock on the date you exercise the option.

The date you sell the stock you acquire with the option

If the option is granted under a specifically qualified plan, called an Incentive Stock Option, or ISO, you report income an pay tax based upon the difference between the price you pay for the stock under the option and the fair market value of the stock on the date you sell the stock you acquired under the option. These ISO Plans have many conditions relating to, among other things:

  • The aggregate number of shares that may be issued.
  • Stockholder approval.
  • Time limits within which option may be exercised.
  • The exercise price of the option not less than the fair market value (or, if the grantee is a 10% stockholder, 110% of the fair market value) of the underlying stock as of the grant date.
  • Not transferable.
  • Amount that can be exercised each year.

Beware of the Financial Consequences to the Recipient

All those pesky questions and the answers you didn’t like in the discussion of Stock Grants above still apply to stock options. With an option, you haven’t avoided the tax liability, just postponed the day of reckoning when you pay the tax.

Beware of the Financial Consequences to Your Company

Stock options pose even greater problems for SEC reporting companies than stock grants. Why? You must do a separate calculation of the value of the options each separate quarterly reporting period and must record the amount as a non-cash expense. All those pesky questions and the answers you didn’t like in the discussion of Stock Grants above still apply to stock options, only in some cases worse because the valuation analysis must be done every time you file your SEC reports.

S-8 Registration Statements for Stock Compensation for SEC Reporting Companies

One of the problems with stock based compensation discussed above occurs when the recipients receive stock that they cannot immediately resell, generating funds to pay the taxes due.

The stock received in stock based compensation is treated by the SEC as restricted, just as if it had been sold in a private placement. All the resale restrictions under SEC Rule 144 that apply to stock sold in a private placement also apply to stock based compensation, restricting the recipients ability to resell the stock to generate necessary funds to pay the tax upon receipt.

The SEC provides partial relief to this problem by allowing a short form, non-reviewed registration statement under the 1933 “Selling Stock” Act on Form S-8. Stock received under an S-8 registration statement is not treated as restricted stock.

Beware That This Does Not Solve All The Problems

  • Your company must be an SEC reporting company.
  • Not all forms of services can be paid with S-8 stock.
  • Officers, directors and affiliates, i.e. insiders, still do not receive fully free trading stock. Although the holding period under Rule 144 is eliminated, the remainder of the resale restriction on insiders under Rule 144 still apply as the securities are not restricted but are still classified as control securities.

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