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Preparation Can Ease Tax Burden of Non-Qualified Stock-Option Plans

November 08, 2000|JUAN HOVEY

If you are considering whether to set up a stock-option plan for your employees, be careful--and take a lesson from Silicon Valley's high-tech industry in how to ease the tax burden that these plans may impose on your employees.

As discussed in this space last week, you have two choices in setting up stock-option plans--a qualified or a non-qualified stock-option plan. As the names suggest, the primary difference between the two is that one qualifies your employee for special tax treatment under federal law and the other does not.

There are, in addition, many other differences between qualified and non-qualified plans, and which you choose for your company depends largely on your own circumstances. In general, however, federal law gives you more room to shape non-qualified stock-option plans than qualified plans.

With non-qualified plans you may:

* Give not only your employees, but also important outsiders--for example, advisors or even consultants who guide you in shaping your enterprise--the chance to buy stock in your company.

* Suit your own needs in fashioning a vesting period or a deadline by which your employees must exercise their options.

* Require your employees to sell their stock back to your company at a formula price based on book value, should they leave your employ.

* Permit your employees to transfer their options to others--for example, to family members or to charitable organizations as part of an estate plan.

* Permit your employees to buy stock in your company at a price other than its fair market value.

The last of these choices, however, comes with a price; without careful planning, a non-qualified stock-option plan may impose substantial tax burdens on your employees. Take, for example, a start-up heading toward a public offering of its stock. Assume that the company values its stock at $1 a share and that its non-qualified stock-option plan allows the employee to buy shares at 50 cents each.

An employee exercises the option, paying $50 for 100 shares--that is, paying $50 for stock actually worth $100. Tax law sees the difference--$50--as income subject to taxation at ordinary rates. Now, for most people $50 does not create a big tax burden, but if you multiply those numbers by the options available to insiders at many a start-up, you see the problem.

The alternative, however, is worse. In the absence of a carefully planned non-qualified stock-option plan, what happens at most start-ups is that the employee does not exercise an option to buy stock until he or she gets ready to sell it--at which point the gain all becomes taxable at ordinary rates.

The solution--an increasingly common practice among Silicon Valley start-ups--is to shape your plan to allow the employee to treat the transaction under Section 83(b) of the Internal Revenue Code, according to Karen Goodfriend, a partner in the Palo Alto financial planning firm GoldsteinEnright Financial Advisers Inc. Goodfriend, a CPA, holds certification as a personal financial specialist, or PFS, from the American Institute of Certified Public Accountants.

In essence, the strategy allows the employee to purchase the stock now, pay tax at ordinary rates on the gain realized in the transaction--$50 in our example--and win capital-gains treatment when selling the stock down the road. If the employee satisfies the waiting periods imposed not only by tax law but by the Securities and Exchange Commission and the underwriter in a public stock offering, this means taxation at long-term capital-gains rates, not at ordinary-income rates, Goodfriend said.

Clearly, she added, a non-qualified stock-option plan may allow employees to store wealth for the future with favorable tax treatment--a big plus for the employer seeking to attract and retain good people. But good planning is crucial.

"On the employer side, you need professional advice in structuring a plan to suit your needs," she said, "and on the employee side, you need professional advice in taking advantage of the plan."


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