Rethinking Equity Plans for 2005 and Beyond
As Published in Mass High Tech

By Jeffrey D. Solomon, CPA, CVARecent changes in how companies must account for stock options have created a swarm of activity by management teams trying to find new alternatives that work better for their companies. The Financial Accounting Standards Board (FASB) recently proposed standards that would require public companies to expense the “fair value” of stock options on their financial statements starting in 2005. Congress is also monitoring the situation with stock option expensing and it appears will also weigh in on this as well. Most likely, this will have a negative impact on future operating results. In fact, even private companies will have to expense all employee stock options starting in 2006, if the proposal passes. Due to these changes, companies are beginning to look at new types of stock compensation plans. In fact, Microsoft recently announced that they will begin issuing restricted stock grants to employees instead of stock options.

There are many benefits from a well designed equity incentive plan. The plan should not only motivate employees to enhance the value of the Company, but should also attract and retain the best employees available. Additionally, an added benefit of stock compensation plans is accomplishing this without having to pay out a lot of cash today.

This article will describe two viable alternatives to the typical stock option plan that many of our emerging companies are beginning to consider.

Phantom Stock plans
The Phantom Stock plan, referred to by some as a “mirror plan,” allows the employer to basically give the employee the appreciation in the Company’s stock from the date of grant to the time the employee cashes it in. Generally, these amounts are paid out over time to the employee. Under a phantom stock plan, no stock is actually given to the employee. Rather, the employee receives a right to the increase in value of the stock, as ordinary income, over the life of the plan. This type of plan is vastly different from other plans, in which an employee ultimately has ownership of stock. It allows the employer to retain and attract key employees without having to give up equity or cash today. Upon an “event,” the employee will recognize ordinary income for the appreciation in value through their W-2, and the Company will get a corresponding deduction for tax purposes. For financial statement purposes, the Company will charge appreciation of the employee's “stock” to expense each period.

Restricted Stock plans
Under the Restricted Stock plan, the Company grants shares of stock to its employees. However, this may not accomplish the goal of retention, which should be the key goal of a stock compensation plan. To serve this purpose, management can put contractual restrictions on these shares (or grants of shares) that will basically allow the employee to vest in their stock over time, thus locking them up. Many Companies put restrictions such as time, while others may use milestone objectives, such as profitability or even sales targets for its employees in its sales department. For tax purposes, the employee must pay taxes at ordinary rates as the restrictions lapse, and the Company gets a corresponding deduction.

However, under a special provision of the IRS code, section 83, the employee is allowed to make an election to pay the tax, today, upon the value of the grant. The tax is imposed on the excess of the current fair market value of the stock over the amount that is paid for it. The election is made by the employee. The election is made when the employee sends the IRS a statement within 30 days of the grant that he/she has elected under this code section, to recognize the gain and pay the tax today. This statement must describe the shares, the date of the transaction, the quantity of shares, and the fair market value and exercise price per share. This allows the employee to pay the tax today, most likely at a lower value than in the future, and also allows the individual to reap the capital gains benefits in the appreciation from that point forward, assuming the normal one year holding requirement is met.

Stock option plans have historically been a great way to provide additional compensation to employees without recording compensation expense for financial reporting purposes. The new standard will likely eliminate this alternative and create additional complexity for the calculation of the expense. However, simply eliminating these plans is probably not a viable option for company management. Restricted stock and phantom stock plans are good alternatives that should be explored.

Jeffrey D. Solomon is a CPA and partner with the accounting and business consulting firm Levine, Katz, Nannis + Solomon P.C. and helps head up their emerging business and technology group. He can be reached at jsolomon@lknscpa.com

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