Stock Compensation Plans Compared and Contrasted Date: 9/24/09 The current economy has offered an opportunity to review the advantages and disadvantages, as well as the book and tax treatments, of the various types of stock compensation that banks use to compensate and incentivize executives.  These include incentive stock options (ISOs), non-qualified stock options (NQSOs), restricted stock and phantom stock.  The status of the economy and resulting bank stock values may cause one type of stock compensation to be more attractive and manageable than another type, thus the opportunity for review.  We will discuss each type separately. Incentive Stock Options (ISOs) ISOs will confer beneficial tax treatment to the employee in the form of trading current compensation at ordinary tax rates for future capital gains.  The employee doesn’t recognize income until the shares are sold, thus the employee should come out ahead on gains realized upon sale (assuming capital gain rates stay lower than ordinary rates).  The amount of capital gain will be the difference between the sales price and the option price paid.  In general, ISOs must meet the following IRS prescribed requirements: The option price must not be less than the fair market value of the stock on the date of grant and must be exercisable with ten years from date of grant. The employee cannot own stock with more than 10% of the total combined voting power of all voting shares. The employee must be an employee from the time the option is granted until three months before the option is exercised. The employee cannot dispose of the stock resulting from the exercise of the options within two years of the date of grant. The employee must hold the stock for at least one year after exercise.  If the stock is sold within the required one-year holding period, a ‘disqualifying disposition’ results and the gain on the sale is treated as compensation rather than capital gain (although will not be subject to income or employment tax withholding if the options were exercised after October 22, 2004). Book Treatment – Generally, when ISOs are granted, compensation expense is booked in an amount equal to the fair value of the option on date of grant times the number of vested options granted (nonvested options will book as compensation as they actually vest or performance occurs).  At the date of exercise, common stock and APIC are credited. Tax Treatment – For tax purposes, ISOs when granted are not compensation to the employee; therefore, no tax deduction is allowed for the amount of compensation deducted on the books.  This normally results in a permanent book-tax difference.  However, should the employee sell the stock before the one-year holding period is up, the result will be compensation income to the employee.  The bank will be allowed a corresponding compensation deduction.  Non-Qualified Stock Options Non-qualified stock options (NQSOs) are stock options that do not meet the above requirements to be an ISO.  As opposed to ISO’s, they will have elements of both compensation income and capital gain income (could be short- or long-term) to the employee.  Book Treatment – Same as for ISOs.   Tax Treatment – In contrast to ISOs, NQSOs are taxable upon grant as long as the stock has a readily ascertainable fair market value (defined very specifically in the Code).  Because the value of most community bank stock won’t meet the narrow definition of ‘readily ascertainable’, bank NQSOs are generally taxed to the employee upon exercise.  The amount of income is the difference between the fair market value of the stock and the exercise price the employee paid for it.  The bank would get a corresponding compensation deduction.  Short-term or long-term capital gain results when the shares are sold, depending upon the holding period, which begins the day after exercise.  Since both the book and tax treatment will result in a compensation deduction, only at different points in time, a timing difference results affecting the deferred tax calculation (unlike ISOs sold after the one-year holding period).  Restricted Stock Restricted stock is different from ISOs and NQSOs in that actual stock is awarded, not just an option to buy stock; however, there are restrictions on the stock relating to the recipient’s ability to fully own, sell or otherwise dispose of the stock.  It is common for full ownership of the stock to vest after specific increments of time e.g. 25% ‘vests’ after each year of performing services for four years. Or, the stock vests when certain performance goals are met. Book Treatment – Restricted stock is expensed as compensation for the fair value of the stock as it vests (or is earned through service).   Tax Treatment – As long as the restricted stock is nontransferable and subject to a ‘substantial risk of forfeiture’, an employee won’t recognize income until the risk lapses.  If the vesting of the stock is conditioned on the performance of future services, a substantial risk exists.  Thus, in the case of stock vesting incrementally over time and the performance of services, the employee will recognize income at each such increment when the stock becomes fully owned.  The amount of income (which is subject to withholding in a method specified in the stock agreement) equals the fair market value of the stock at the time it vests times the number of shares vested during that particular increment of time.  The bank will be allowed a corresponding compensation deduction at the same time the income is recognized by the employee.   83(b) Election – One option available to employees receiving restricted stock is to make what is called an 83(b) election which allows the employee to recognize for tax purposes the value of the entire amount of the restricted stock grant at date of award, rather than incrementally over time.  This could be advantageous if the fair value of the stock is low at the date of award, the employee is unlikely to forfeit any shares, and the value is expected to increase substantially.  If this is the case, then when the shares are sold, they may be subject to tax at long-term capital gain rates.  However, if the employee pays the 83(b) tax, then subsequently forfeits the shares for whatever reason, no refund may be obtained.  This election must be made within 30 days from the date of the award.  Obviously, this is an election that should be made with careful consideration. As with NQSOs, the timing of the compensation deduction for tax vs. book purposes can result in timing differences that will enter into the deferred tax calculation. Phantom Stock Phantom stock is more like a deferred compensation plan than a stock ownership vehicle.  Phantom stock doesn’t award actual stock but instead uses the calculation of dividends or appreciation on actual stock to determine amounts of deferred compensation that are credited to an employee’s ‘account’ for future payment at retirement.  The employee is usually awarded a number of ‘units’ (determined by the administrative committee) where each ‘unit’ earns the same amount of deferred compensation as one share of stock earns in dividends, or appreciates in value.  For example, if one share of stock would receive $100 in dividends, the employee has been awarded 10 ‘units’ of phantom stock, then $1,000 will be credited to the employee’s deferred compensation account for future payment.  In addition, the account may be credited with increases in the market value of the stock.  This has the advantage of tying compensation to stock performance while not actually diluting the interest of the actual stockholders.  Phantom stock may also work well for younger executives who don’t possess the resources to exercise stock options. Book Treatment – Compensation expense is booked for the amount of deferred compensation credited to the employee’s account (a liability account).  When the payments are made in the future, the liability is debited.   Tax Treatment – The employee will be taxed when the deferred compensation is actually received at retirement (when the employee is likely in a lower tax bracket).  The bank receives a corresponding compensation deduction when the employee recognizes the income.  This results in a timing difference between the book and tax treatment.