Attract, Retain, Reward: Stock options not just for large corporations

Stock options are not just for large multinational corporations. Stock options and other more advanced deferred compensation tools offer companies many opportunities to attract, retain and reward key employees while also providing many tax advantages.

With the current staffing shortages that many businesses face and the many employers offering these tools, considering these strategies should be a top priority both for employers and employees.

Stock options are a mechanism whereby a company grants an employee the option to purchase shares of equity in the company, often on a date in the future and for a set price. An employee realizes the benefits from stock options when they exercise their option, purchase the stock at the exercise price and then sell it at a higher price (commonly referred to as monetizing). Publicly traded companies most often use this tool as it allows the company to compensate employees with these stock options rather than cash.

Stock options aren’t just for publicly traded companies. A fast-growth company that has a target of private equity or other means of additional downstream capital funding would be an ideal candidate for using stock options to attract highly qualified employees who are willing to see the long-term benefits. As with publicly traded companies, these fast-growth companies (and many of them here in northern Michigan) have the future trigger events necessary for employees to monetize their options.

Often these fast-growth companies need to attract highly skilled employees but are limited by current cash flow constraints. Using stock options provides the mechanism to fairly compensate current work with less cash now while providing the longer-term upside potential that an employee who believes in the mission would be willing to benefit from.

Restricted stock units are actual outright ownership of stock but come with stipulations on when they can be sold (referred to as vesting). As with standard stock options, it is often assumed that RSUs are only available to publicly traded companies. However, when properly developed, RSUs can offer many positive benefits provided by stock options but with fewer compliance requirements. Since an RSU is a direct award of actual stock (just restricted), it avoids the often prohibitive need to exercise an option to purchase the underlying stock.

This exercise often requires the holder to sell some of the stock to afford the transaction and can minimize the effects. Further, selling shares may not even be possible for a privately held company.

Since an RSU is a direct stock award, the holder doesn’t need outside cash to acquire the stock – they already own it. RSUs also alleviate a common drawback of stock options in that stock options are only valuable if the stock’s market value is higher than the grant price. Otherwise, the employee is paying more for the shares than they, in theory, could purchase them for on the open market.

phantom stock plan is an employee benefit plan where eligible employees (and their employer) can receive many of the benefits of stock ownership without actually owning company stock. These plans are available with significantly lower compliance costs and do not require outside purchases like publicly traded stocks or cash infusion events.

A phantom stock plan essentially is a long-term defined bonus plan with awards tied to overall company value generation, as if the employee were an owner. As with stock options and RSUs, both the company and employees benefit from deferred income streams combined with long-range growth.

With a phantom stock plan, the employee benefits from company growth (that, in theory, they are directly responsible for) while not being burdened by complicated flow-through income impacting their tax returns often associated with privately held companies, the legal liabilities related to stock ownership, or ongoing compliance requirements. However, offsetting these upsides is less favorable tax treatment in the long run, ultimately resulting in less overall wealth generation than the alternative strategies.

It shouldn’t come as a surprise that there are different circumstances in which each of these strategies makes more sense than the others. They should be viewed similarly to various tools in a toolbox, each with a different intended use. As the saying goes, “the larger the risk, the larger the reward.” Each of these tools offers pros and cons for both the employee and the employer that need to be considered. All three have different tax and compliance complexities, different levels of commitment, and different long-term goals that need to be weighed for both the company’s and the individual’s circumstances.

Suppose you are an employee of a company offering stock options, restricted stock units, or phantom stock – congratulations on diversifying your overall compensation and wealth generation opportunities.

With that diversification and potential increased benefits come some complexity and planning opportunities that need to be considered. If you are a business owner exploring creative ways to compensate your current employees or attract new employees to your company, stock options, restricted stock units, or phantom stock plans may be the tools you should be considering to award your employees and differentiate your business in the marketplace effectively and efficiently.

Jon Sluis, CPA, is president of Intrust CPA in Traverse City. With a background in public accounting and private industry, he has more than 20 years in the industry. Specific areas of expertise include federal taxation law, tax credit financing, long-range strategic and financial planning, entity structuring, financial improvement measures, and financial reporting. For more information, call (231) 935-1590 or visit www.intrustcpa.us.

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