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Understanding the Use of ISOs in an Employee-Owned Company

ESOP-owned companies may choose from a variety of incentives to help attract and retain key leaders. Read on for details on establishing an ISO plan.
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Employee stock ownership plans (ESOPs) provide the ability to help attract and retain key management teams. With a tight labor market, ESOP-owned companies may choose to offer a competitive compensation package that includes a combination of short-term and long-term incentives. The intent of the compensation package for key leadership is to design equitable compensation for their members and entice them to stay with the company. The short-term incentives may include the base compensation with annual cash bonuses. The long-term incentives also may include a deferred compensation plan. Deferred compensation plans provide key leaders the ability to obtain synthetic equity in the company over a period of time. Long-term incentive plans can be used to align the interests of senior leaders with those of the ESOP. This could be accomplished by establishing an incentive stock option (ISO) plan for key leaders.

ISO Plan Structure

Under an ISO plan, the key leadership team becomes eligible to receive a specified ownership interest in the company over a period of time. When implementing an ISO plan in conjunction with an ESOP transaction, the management incentive pool is negotiated and approved by the ESOP trustee. The ESOP trustee looks to determine if the ISO pool is fair and reasonable when considering both total dilution to the ESOP and individual market levels of compensation. The board of directors also should evaluate whether the ISOs are reasonable compensation and may consider obtaining a compensation study.

The ISOs will typically be granted after closing the ESOP transaction, based on the company’s value on the grant date. A post-transaction valuation will need to be performed to determine the fair value on the date of grant. In a 100% leveraged ESOP transaction, generally the value is low due to the additional leverage incurred to effectuate the transaction. The ISOs are subject to a vesting schedule. The vesting schedule could be time-based, performance-based, or a combination of the two. Either way, the option holders will have a period no longer than 10 years from the grant date to exercise the ISOs.

As the company pays down transaction debt, the value of company stock is expected to appreciate in value. Because the ISOs are tied to the ESOP valuation the ISO holders also see their options appreciate in value as debt is being repaid. When the ISO holders exercise all or a portion of the vested ISOs, the ISO holder will exercise the options and have two choices on receiving the deferred compensation.

Exercise Options & Tax Implications

The first option is to exercise the options and immediately “put” the shares back to the company. The put price of the ISOs is based on the most recent ESOP appraisal. The IRS considers this a disqualifying disposition and the difference between the put price and the exercise price multiplied by the number of options exercised is considered ordinary income. The ordinary income is recorded in box 1 of a Form W-2 and taxed at the individual holder’s ordinary income tax rate. However, a disqualifying disposition is not subject to income or payroll tax withholding.

The second option is to exercise the options and have the option holder hold the stock for more than one year before putting the shares back to the company. This second option allows the ISO holder to take advantage of long-term capital gain rates. Assuming the company is an S corporation during the holding period, the option holders will need to consider income taxes that will be due based on their proportionate share of corporate taxable income. Once the shares are “put” back to the company, the price will be based on the most recent ESOP appraisal.

Prior to the exercise, the option holders will need to perform an analysis of holding the shares for one year versus immediately selling their stock based on income tax laws in effect at the time and other factors.

Alternative Minimum Tax (AMT) Implications

If the option holder elects the second option, that individual may be subject to AMT. The difference between the option’s exercise price and the stock’s fair market value at the exercise date is generally not subject to regular federal income tax. However, the difference is an AMT preference item to the option holder in the year the option is exercised, and some AMT may be owed by the option holder. Any AMT paid becomes an AMT credit that may be available in the future as a credit against regular federal income tax or may be used to offset all or a portion of the capital gain tax resulting from the sale. Subsequent to the exercise of the option, the option holder’s basis in the stock for AMT purposes is the fair market value of the stock at the date of exercise.

Other Tax Implications

Based on IRS rules, a maximum of $100,000 (based upon the stock’s option price) of stock options per option holder may become exercisable in a given year. Any options granted in excess of the $100,000 limit will be treated as nonqualifying stock options and will be taxed as ordinary income upon disposition.

When an ISO is exercised, the company must file Form 3921. A Form 3921 must be filed by any corporation that has an employee who exercises ISOs in the last tax year and informs the IRS which shareholders received ISO compensation. The company must file one form per ISO exercise by the March 31 due date.

An ISO plan can be an effective tool for attracting and retaining executives in an ESOP-owned company. If you have questions or need assistance, please reach out to a professional at FORVIS or submit the Contact Us form below.

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