Equity compensation planning when markets are in turmoil
ARTICLE | April 28, 2023
Authored by RSM US LLP
What happens to equity compensation when stock prices fall? In periods of growth and expansion, equity compensation arrangements and incentives are attractive to employees and employers alike. However, inflation, rising interest rates, high energy prices, and a volatile stock market have made the potential for an economic slide top of mind for many. RSM’s Q4 2022 Middle Market Business Index survey indicated that one critical benefit middle-market employees desire from their employer is equity or share ownership in their organization, but how can an equity award retain its attractiveness in a softer economy? What can employees do in a recession to salvage equity granted to them in periods of growth? The answer depends on the type of equity arrangement each employee holds and whether their employer is also willing to take steps to adjust the arrangement to suit the economic climate.
Incentive stock options
Incentive stock options (ISOs) are an attractive equity compensation method when prices are rising because employees who hold their stock until the later of two years from the date of grant or one year from the date of exercise (the “holding period”) are not required to recognize ordinary compensation income on exercise. Instead, income tax is deferred until the eventual sale of the exercised stock, and they receive capital gain treatment at that time. However, employees exercising ISOs are required to record an alternative minimum tax (AMT) adjustment related to the “spread” (the fair market value (FMV) of the stock at exercise, less the amount paid to exercise), potentially subjecting them to the AMT in the year of exercise.
When employees can assume the value of their exercised stock will continue to increase, AMT may seem like a small price to pay for the wealth being generated by the appreciation of their employer’s equity. When employees exercise ISOs during or just prior to a period of falling prices, however, the AMT adjustment and tax deferral appear less attractive. In such scenarios, paying AMT on the value of stock at a price greater than the employee can expect to receive upon future sale makes little sense, and employees can minimize the phantom AMT using a disqualifying disposition strategy.
Disqualifying dispositions are any sale of exercised ISO stock prior to the end of the required holding period. The disqualifying disposition changes the taxation of the income related to the spread. When done in the same taxable year as the exercise, this removes the requirement to recognize an AMT adjustment. Disqualifying dispositions require the employee disposing of their ISO stock to recognize ordinary compensation income of the spread at exercise or, in the case of depreciated stock, the amount received from the sale of the stock. If the value of the stock falls below the amount paid for the shares, there is no compensation income to report and instead, the sale is reported as a capital loss. When employees receive less in return for the sale of their stock than the AMT income they would have recognized at exercise, the ability to pay income tax on only the amount received in a disqualifying disposition may be an attractive alternative.
For example, consider an option-holder who exercises 100 ISOs with an exercise price of $10 on Jan. 1, 202X when the FMV is $50. The employee does not recognize any ordinary income at the time of exercise but has a potential AMT adjustment of $4,000 on their 202X tax return. (Spread of $50 - $10 = $40 x 100 units = $4,000.) During 202X, the market tumbles, and by Dec. 1, 202X, the FMV of the employee’s stock is $30/share. The employee may choose to sell the stock in a disqualifying disposition before year-end to escape the phantom AMT or may choose to hold the stock and sell at a later date during the next year, 202Y, hoping for a rebound in stock price. See the chart below for the tax consequences at the highest marginal federal rates (37% ordinary income, 20% capital gains, and 28% AMT) in three potential scenarios: sale of all shares on Dec. 1, 202X, sale of all shares on Feb. 15, 202Y, or sale of all shares on Nov. 30, 202Z (two years after exercise). Note that the AMT adjustment in the year of exercise reverses when the stock is eventually sold, and any AMT paid is eventually available as a credit in years when regular tax exceeds AMT.
Nonqualified stock options
The tax treatment of nonqualified stock options (NSOs), defined simply as stock options that don’t meet the requirements under section 422 for ISO treatment, differs from the ISOs mentioned above. Employees who exercise NSOs are required to recognize ordinary compensation income equal to the spread – the FMV of the stock at exercise minus the price paid on the date of exercise. Any gain or loss on the sale of the stock post-exercise is subject to capital gain treatment.
Employees holding NSOs can minimize their tax burden by timing the exercise of their options carefully. Exercise prices are set at grant, and employees are not required to exercise immediately as options vest. In many cases, the option exercise window may be up to 10 years from the date of grant, so periods of volatile prices offer employees the option to wait to exercise until the FMV of the underlying stock is close to their exercise price, reducing their ordinary income tax burden. Employees may also be able to ‘net exercise’ which limits a direct cash outlay by selling a certain amount of the exercised stock to cover the exercise and tax costs. If the stock price of the exercised options continues to fall, employees who sell their exercised stock will recognize a capital loss, which nets with their capital gains, and if any remains, $3,000 of capital loss is deductible against their ordinary income each taxable year. In addition, options that are “underwater,” i.e., options that have an exercise price greater than the current FMV of the underlying stock, may never make sense for the employee to exercise since they could theoretically purchase the stock at a lower value on an open market. Similarly, underwater options in a private company may prove too risky to exercise if it is uncertain whether the stock price will ever recover.
Though employees can avoid the negative consequences of underwater options by choosing not to exercise, options are used by employers to incentivize employees to remain with a company on a longer-term basis. Underwater options no longer hold that incentive. In such situations, employers may consider repricing the options. Repricing can restore the incentive of an equity compensation plan for employees but often involves administrative hurdles like rewriting legal documents or obtaining shareholder approval.
Repricing options can take multiple forms. An employer can amend its option awards to use a new, reduced strike price that reflects the current FMV of the company which will renew the incentive for their employees to remain employed with the company. The employer can cancel the original options and reissue new option awards with the lower exercise price. The amendment or re-issuance of an option agreement does not have any immediate tax consequences for the employees or employer, but in both situations, the new price must be equal to or greater than the FMV of the underlying stock at the time of repricing to remain exempt from the deferred compensation rules in section 409A. Extensions of option agreements due to an underwater option strike price are also characterized as the grant of a new option. Any modification or grant of new options must be carefully evaluated with regard to section 409A to confirm its categorization as an excludable stock right or plan to comply with section 409A.
Employers can also cancel their outstanding stock options to replace them with other remuneration. Cancellation of underwater stock options for cash results in immediate compensation income for the affected employees (and corresponding deduction for the employer) but doesn’t provide any additional motivation to remain with the company. Cancellation of stock option agreements to replace them with another form of equity, such as restricted stock, does not require immediate recognition of income for the employees and may restore the incentive as well
Employers that are concerned about volatile prices and the potential for option agreements’ exercise price to go underwater may wish to consider this when determining the timing of their stock option grants. Timing stock option grants and strike prices to correspond with periods of lower stock value can reduce the chances that the options will go underwater and eliminate the potential headaches of undergoing an option repricing plan.
Resetting other compensation plans
Any compensation method that is tied to the value of a company’s equity may lose its impact during periods of falling prices and market volatility. Restricted stock, restricted stock units, bonus pools, and phantom equity plans may be tied to company performance in an attempt to align executives’ interests with the company’s interests. In addition, other performance goals based on measurement metrics such as EBITDA growth, expansion into new markets, ESG initiative, or other metrics may become unattainable during the performance period due to external market conditions having nothing to do with the performance of the executives in their roles.
When factors outside of the employee’s control, like recessions, make such targets impossible to hit, these plans may disincentivize employees to make decisions on a longer-term basis to drive company growth or may make outside opportunities more attractive. In a down market coupled with low unemployment, employers must consider additional ways to keep their executives engaged.
Employers looking to revitalize employee engagement may consider resetting performance metrics in their equity compensation plans or including clauses that allow for discretion in target measurement. Instead of targets tied to specific stock prices or equity values, these new performance metrics may be better tied to relative growth or specific events like new product launches to incentivize specific behaviors without being outside the employee’s sphere of influence.
In general, amending or canceling and reissuing new agreements will not result in new tax consequences for employees or employers but care must be exercised to examine the new plan for section 83(b) and section 409A considerations, if applicable.
For example, employees may have made section 83(b) elections to include restricted stock in their taxable income at the time of grant. If the vesting of that restricted stock is tied to performance metrics that are now unattainable, employees will have paid tax on equity compensation that they’ll never receive without an amendment to the original agreement.
In addition, even if those shares do vest, those employees will likely have paid tax at a higher value than the stock value they will receive, resulting in an eventual capital loss upon the disposition of the stock unless prices rebound.
The adjustment of compensation plan agreements is not an unlimited opportunity. Employers must pay close attention to the consequences of existing plans for their employees when markets begin to fall. Once stock has been issued or an 83(b) election has been made, the IRS will only respect rescission within the same tax year. In addition, the cancellation of an agreement may not be undertaken if it leaves either party in an altered position from the one in which they would have been had the original agreement never been made. Hesitation to act may close the window for plan amendment for certain employees, resulting in unintended consequences that will be difficult to correct.
Regardless of market conditions, it’s important for employees to review their overall portfolios on a regular basis, especially when receiving compensation based on their employer’s performance. It’s easy for employees who receive equity compensation to become over-weighted in their employer’s stock. When the company is doing well, the employee may be hesitant to dispose of stock they believe will continue to increase in value, and in downturns, they may wish to hold on to that stock in anticipation of a turnaround. However, in worst-case scenarios, when companies fail, employees holding most of their wealth or other savings in company stock may be left without both a job or a financial buffer. Creating a systematic plan for equity compensation grants commensurate with long-term goals - whether to dispose of or hold stock, while minimizing the tax burden – is in the executive’s best interest.
Employees should also be aware of the “fine print” on their equity awards. Must they sell their restricted stock if they leave the company? Will restricted stock vest upon separation of employment for good reason? Is there a period of time in which they must exercise vested options if their employment is terminated? Many option plans use a post-termination exercise period of 90 days, meaning they must choose to exercise options within three months of ending their employment or lose them entirely. This short period, which is required for ISOs, gives employees minimal time to consider what to do with their vested options if they’re unaware of this clause. When stock prices are unpredictable, the decision-making process becomes even more difficult. It’s a good idea for option-holders considering leaving their employment to make a plan for how and what they’ll exercise as part of their decision-making process.
The considerations around equity compensation are complex, especially when periods of economic instability add a layer of unpredictability to the analysis. It’s best to involve your tax advisor early on when drafting or modifying an equity compensation plan or when making complex decisions about exercising, holding, or selling equity.
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This article was written by Rachel Simon and originally appeared on 2023-04-28.
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