more-arw search

Q&A Forum

Exercise Stock Option with Promissory Note

accounting for stock optionsHello, We are a private company. One of our employees has exercised his stock options by a promissory note. How should this transaction be journalized in our accounting system? Once he makes a repayment, how is that being recorded? Thank you!

Answers

Topic Expert
Keith Perry
Title: Consulting CFO and Business Operations A..
Company: Growth Accelerator
(Consulting CFO and Business Operations Advisor, Growth Accelerator) |

Anon,

It's an employee loan.
Make sure you charge interest and *don't forgive it*.
Repayment is just that; repayment of a loan.

Cheers,

KP

Anonymous
(CFO/Board Advisor) |

I typically discourage companies from allowing option exercises by means of a promissory note. Promissory notes can provide employees a means of exercising options and starting their capital gains holding periods without coming up with cash. However, the promissory notes must be substantially full recourse to start the capital gains holding period, which creates a real obligation for the employee even if the stock eventually becomes worthless. A bankruptcy trustee might attempt to collect on a full recourse note in the event the company goes bankrupt. Full recourse means that the note is a general obligation of the employee, as opposed to recourse being limited to the stock purchased in the event of default.

If the promissory note isn’t substantially full recourse, then the option isn’t deemed to be exercised for tax purposes. If the note is repaid (or forgiven) in the future and there is a difference between the purchase price and fair market value at that time, then the employee may have a taxable event. In addition, if the note is forgiven, it will create debt forgiveness income to the employee.

The accounting for the exercise of the option, the issuance of stock, and the Promissory note is pretty straight forward. However, for GAAP reporting, the Promissory note may end up being a contra equity account until paid. That is there has been no "paid-in" capital until the note is paid.

Personally, I'd discuss this with both my audit partner and tax partner there are a lot of land mines here that could surprise everyone if not done correctly.

Topic Expert
Keith Perry
Title: Consulting CFO and Business Operations A..
Company: Growth Accelerator
(Consulting CFO and Business Operations Advisor, Growth Accelerator) |

Concurring with anon:
-this is a variation on letting an employee gamble with the company's money. If the gamble goes bad, bad things happen.
-Anon also mentioned the "forgiveness" issue. I strongly suggest looking into what happens when you forgive an employee loan. There are flavors of outcomes; the worst flavors are particularly bad (unreported deferred-comp penalties, etc). The IRS has taken action relative to past abuses, and you don't want to be caught in the dragnet.

Some of the variance depends on if they are execs or not.

Some light reading for you: http://www.jebachelder.com/articles/010321.html

Todd Boney
Title: Chief Financial Officer
Company: Glencairn Highlands LLC
(Chief Financial Officer, Glencairn Highlands LLC) |

In addition to interest collected, consider principal payments as well, at least nominal. You'll want to avoid an appearance it's not really a loan - you don't want to have an issue collecting the note when/if the employee leaves before there is a liquidity event. As you know, collecting monies from departing employees can be challenging in certain states. Make sure that your personnel documentation/communications consider the right of the company to offset the loan balance with unused vacation pay, bonuses, commissions etc. should the employee leave the company.

Topic Expert
Edward Abbati
Title: Vice President of Finance
Company: Location Labs
LinkedIn Profile
(Vice President of Finance, Location Labs) |

I just went through this issue with my company and will re-iterated some of the issues mention above:

1. It must be a recourse loan; otherwise, you lose any tax benefit of exercising those options. Please note that the Accountant's and Attorney's will differ on what it means by "recourse". In the Accounting world "recourse" implies you can go after the person's personal assets while the Attorney's may write up the note so that the worst case for the person is that he/she must return the shares. In that case, that Accountant's will not want you to show the options as being exercised on the books although from a tax perspective it still may qualify for capital gains.

2. Don't infer or imply the loans may be forgiven. In our case the loans were paid but the employees were given a bonus later on.

3. In our case, our Accountant's advised us to keep the loans off the Balance Sheet.

4. Make sure you charge an interest rate that meets the IRS guidelines.

5. You can amend the notes to extend them, but only onetime; otherwise, it may not pass IRS scrutiny.

6332 views

Get Free Membership

By signing up, you will receive emails from Proformative regarding Proformative programs, events, community news and activity. You can withdraw your consent at any time. Contact Us.

Business Exchange

Browse the Business Exchange to find information, resources and peer reviews to help you select the right solution for your business.

Learn more

Contribute to Community

If you’re interested in learning more about contributing to your Proformative community, we have many ways for you to get involved. Please email content@proformative.com to learn more about becoming a speaker or contributing to the blogs/Q&A Forum.