Setting Up a Stock-Option Plan

Worried about attracting and retaining good employees? Are you thinking of establishing a stock-option plan to solve your problem?

Whether you run a publicly traded or privately held corporation of any substantial size, a carefully crafted stock-option plan makes a great deal of sense--and you have two choices when putting one together:

* A qualified stock-option plan--qualified in the sense that, under federal law, such a plan qualifies your employee for special tax treatment.

* A nonqualified stock-option plan--nonqualified in the sense that your employee does not qualify for special tax treatment.

In either guise, stock-option plans form an important part of the financial structure of any growing incorporated business because, like the 401(k) and phantom stock plans recently discussed in this space, they tie the fortunes of the individual employee to those of the employer--key to long-term performance. They are also relatively easy to set up and administer, and because they involve stock, not cash, they don’t eat into your company’s most precious commodity.

Stock-option plans are popular too. The National Center for Employee Ownership estimates that between 7 million and 10 million employees receive stock options in the U.S., up from 1 million a decade ago. Among venture-backed high-growth companies in the technology industries, stock-option plans are even more popular: In a survey taken a year ago, the center discovered that fully 83% grant stock options to all newly hired employees and the rest grant options to key employees only.

Employers of all stripes opt for stock-option plans because they give their employees a tax-sheltered means of storing wealth for the future. With a qualified stock-option plan--often called an incentive stock plan--they also give employees an immediate tax advantage, according to Karen Goodfriend, a partner in the Palo Alto financial planning firm GoldsteinEnright Financial Advisors Inc. Goodfriend, a CPA, holds certification as a personal financial specialist, or PFS, from the American Institute of Certified Public Accountants; she lists a number of Silicon Valley executives as her clients.

Under such plans, Goodfriend said, the employer grants the employee the right to purchase company stock at a specified price within a given time period--usually 10 years. The stock may be common or preferred, with or without voting rights.

The employee pays no regular income tax when exercising the option--that is, when actually buying the stock--with one caveat: Depending on the circumstances, the transaction may subject the employee to the whimsies of the alternative minimum tax. Instead the employee pays taxes only after selling stock obtained through such a plan, usually at favorable capital gains rates, not at the rates for ordinary income. (The distinction is substantial: The federal government taxes long-term capital gains at 20%, sometimes less, and ordinary income at a maximum exceeding 39%.)

In addition, Goodfriend said, employers may lend their employees cash to exercise their options and they may design their plans to benefit only key employees whose work most directly affects the bottom line.

On the downside, Goodfriend said, federal law restricts how you may structure a qualified stock-option plan--for example, by imposing complex limits on the value of the options your employee may exercise in any one year. In addition, in a qualified plan:

* The exercise price--that is, the price at which your employee may buy your company stock--must equal or exceed the fair-market value of your stock on the date when you grant the option. For publicly traded stock, the fair-market price is the price at which the stock trades on the date of the option. Privately held corporations may value their stock by any reasonable method, which may or may not include a formal valuation.

* You may not offer options to anyone other than your employees--meaning that you can’t use these plans to compensate valuable outside advisors or consultants.

* Your employee must exercise the option--that is, actually buy your company stock--within 10 years of the date of your grant, and within three months after his or her departure from your employ.

* Your employee may not transfer his or her right to the option--for example, by giving it to a family member or to a charitable organization.

The restrictions aside, qualified stock-option plans give the employer a powerful weapon in designing incentives for employee performance, Goodfriend said, and they give the employee a weapon of equal potential for storing wealth.

“Nonqualified plans are more flexible,� she said. “Qualified plans are more restrictive, but they have potentially better tax implications for the employee, depending on how carefully the employee plans the actual buying and selling of stock.�

Next: How Silicon Valley’s technology industry overcomes a disadvantage to nonqualified stock option plans.

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Recent Financing and Insurance columns are available at http://ukobiw.net./finin. Juan Hovey can be reached at (805) 492-7909 or at [email protected].