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Incentive Stock Option Plan

Our company is wanting to recognise the efforts of our employees over the last couple of years, but cant afford to increase salaries, so the board wants to establish an Incentive Stock Option Plan, and issue employees options.  We have established a Plan, and form of Stock Option Agreement which we are confident meet IRS standards, but I am unsure what registrations or IRS approvals are needed. We are a private Delware company, located in California. Are there registrations of filings required with IRS, home state or employment state, and if so do they have to be done up front, or when or if the Company starts offering stock to the public? I have seen some companies filing a 25102 with the California Commission of corporations, and I have seen others who know nothing about such filing?
 

Answers

Topic Expert
Joan Varrone
Title: CFO
Company: Cloud Cruiser
LinkedIn Profile
(CFO, Cloud Cruiser) |

You should ask your corporate counsel about the required filings. However one thing you will need to do as a private company is get a 409A valuation performed by a competent independent third party to determine the strike price for the options. If you were to grant options below their fair value there would be negative tax consequences for your . If you are in the Bay Area I can provide you with the name of some good 409A valuation firms.

Keith Taylor
Title: CFO
Company: Lyris, Inc.
(CFO, Lyris, Inc.) |

Simon, while I am aware of the reporting, I agree you should check with counsel if you're concerned. During my VC-backed company stints, I have used all the biggies in the Bay Area (Wilson Sonsini, Fenwick, Cooley Godward, Baker MacKenzie) and they never recommended filing anything with any regulatrory agency, with one exception -- Magellan Navigation had more than 500 awardees, and thus requiring SEC filing/financial disclosures of audited financial information.

For fun, check this Jon Stewart rant on Facebook's LACK OF FILNG its PLANS (if they can avoid filing, so can you ;-)

http://www.thedailyshow.com/watch/thu-january-6-2011/the-anti-social-network

Jeff Taylor
Title: CFO
Company: Communications Co.
(CFO, Communications Co.) |

Simon, here is a great overview of what you need to do to set up your equity plans in CA - from a very well known law firm: http://www.orrick.com/practices/corporate/emergingCompanies/startup/forms_equity_compensation.asp.

Disclaimer: I'm no lawyer :).

The filings are not with the IRS, but with the state. You have to file a 25102(o) exemption with CA (counsel will prepare the form) http://www.corp.ca.gov/forms/pdf/25102o.pdf.

An 83(b) election may need filing with the IRS when exercising restricted stock. Learn more here: http://www.fairmark.com/execcomp/sec83b.htm.

Achaessa James
Title: Product Manager
Company: National Center for Employee Ownership
(Product Manager, National Center for Employee Ownership) |

Hi, Simon. I also include the disclaimer that I am not an attorney, but I am a Certified Equity Professional, and I can confirm that any company that offers stock options to employees in California, no matter where that company is incorporated, must file a Form 25102(o) or be exempt from filing. Here is a good resource for that and additional issues you ask about - http://www.methvenlaw.com/Practice-Areas/Corporate-LLCs-LLPs-Shareholders/Stock-Option-Plans.html

The IRS does not require any filings, but Joan is correct, you will need a professional 409A valuation if you want the easiest way of complying the IRS's safe harbor provisions.

One of the most important service provider selections a start-up can make is using corporate counsel that knows the rules that go with equity compensation plans. Equity compensation is one of the most highly regulated activities, requiring compliance with corporate and securities laws (state and federal), tax laws (corporate and employee withholding), accounting standards, and if you have employees in multiple states/countries or employees that are mobile between multiple locations it gets even more complicated. You should ensure that you select counsel that understands all of these complications and that the person that is administering your option plan is a CEP.

Topic Expert
Simon Westbrook
Title: CFO
Company: Aargo Inc.
( CFO, Aargo Inc.) |

Thanks. That link you provided was very helpful!

Achaessa James
Title: Product Manager
Company: National Center for Employee Ownership
(Product Manager, National Center for Employee Ownership) |

You're welcome, Simon. Please also let me know if you'd like any additional plan administration resources. I am very active in the equity compensation community.

Elizabeth Dodge
Title: VP
Company: Stock & Option Solutions
(VP, Stock & Option Solutions) |

Also not a lawyer, but am a Certified Equity Professional (CEP).

One other editorial comment here... many private companies choose to offer Incentive Stock Options (ISOs) instead of Non-qualified Stock Options (NQs or NSOs) because of the perceived benefits of the ISOs (better tax treatment if the ISOs are held for specified period of time, etc.). However, most employees never reap the benefits of these specialized instruments because they fail to hold the options / stock for the required period. And the administration is a good deal more complex and the rules are often confusing to the optionee. (Also, when you get into the accounting ISOs are "more expensive" because their expense is not offset by a deferred tax asset.)

Some stats have shown nearly 95% of all ISO exercises are same-day sales (exercise the option and sell immediately) which immediately disqualifies the option from the preferential tax treatment. Lots of extra work and effort, no extra benefit.

So I would suggest you carefully weigh the pros and cons of ISOs vs. NQs before leaping into the land of ISOs.

Achaessa James
Title: Product Manager
Company: National Center for Employee Ownership
(Product Manager, National Center for Employee Ownership) |

I agree with Elizabeth about thinking twice before settling on ISOs, especially as used in private companies like yours where there is no market for selling the options once they are purchased. Even though the exercise of ISOs do not trigger ordinary income tax on the gain at the time of exercise (the difference between the exercise price and the fair market value on the date of exercise), the exercise will trigger an Alternative Minimum Tax review when the employee prepares the tax return for the year of exercise and the employee will have to pay the larger of the regular ordinary income tax (on wages) or the AMT taxable income (which includes the exercise gain and disallows some basic deductions like mortgage interest). The calculations are pretty complicated and a tax professional should be consulted, but basically what happens is that if the gain is large enough and/or if the employee is a highly paid executive, the exercise can trigger an AMT tax which will then complicate the taxpayer's situation for several years to come - apart from not being able to sell the ISO stock to either cover the tax or trigger a disqualifying disposition before the end of the year of exercise. This may sound far-fetched, but I had one consulting client that had granted options at $0.75 per share and the year before their planned IPO many of their senior executives were exercising their ISOs when the stock price was up to $7.25 per share in order to meet the 1yr post-exercise holding period. The industry changed, the IPO fell through, and many of those executives were caught between a rock and a hard place when their tax returns came back with AMT due. AMT tax liability is not pretty, which is why we recommend that employees consult with their tax advisors BEFORE making an option exercise to understand the tax consequences in advance.

Topic Expert
Simon Westbrook
Title: CFO
Company: Aargo Inc.
( CFO, Aargo Inc.) |

It would certainly seem that NQOs are better for the company than ISOs. At tax time following an employee exercise and sale, the Company has the ability to book the entire employee compensation, being the difference between grant price and realised price as an expense. For ISOs, I believe the allowed expense is the difference between the exercise price and the actual realised price, however, sometimes, when an employee has left or leaves the Company between exercise and actual sale, it can be difficult to track, and therefore claim the option "expense" leading to lost opportunities.

Achaessa James
Title: Product Manager
Company: National Center for Employee Ownership
(Product Manager, National Center for Employee Ownership) |

Hi, Simon. For ISOs the company does not get any tax deduction unless the employee sells the stock before completing the required holding period (2 yrs after grant AND 1 yr after purchase) which creates a disqualifying disposition. As Elizabeth points out, that's about 95% of the time for public company ISOs because there is a market for the stock, but for private companies there is no market so the likelihood of receiving a tax deduction for a disqualifying disposition is minimal. And, you're right, tracking stock held by a departed employee can be challenging.

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