Equity Compensation
Employers in the U.S. and the UK face a fiercely competitive labor market to hire “tech talent.” While there are a number of factors that sway prospective employees, the availability of equity grants to allow them to share in the company’s success is often crucial.
Private companies typically leverage two key tools for incentive equity: option grants and restricted stock.
Option grants confer upon a recipient the right to purchase common stock/ordinary shares at a pre-determined exercise price and generally are subject to a vesting schedule. There are two main types of option grants: incentive stock options (ISO) and non-qualified stock options (NSO) in the U.S., and enterprise management incentives (EMI) and non-tax favored options in the UK.
Restricted stock are shares of company common stock/ordinary shares that are issued on award to a service provider. Although the recipient of a restricted stock grant receives shares outright, these shares are subject to restrictions that—similar to option grants—lapse in accordance with a vesting schedule.
The chart below summarizes the main types of equity grants that transatlantic technology companies utilize:
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Features
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EMI (UK)
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“Non-tax favored” Options (UK)
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ISO (U.S.)
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NSO (U.S.)
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Restricted Stock (U.S.)
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Restricted Stock (UK)
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Summary
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Only for employees, tax favored treatment which is as low as 10 percent if the option is held for two years
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No favorable treatment
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Only for employees; more favorable tax treatment if held/exercised within specific timeframes
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For any person providing services; fewer limits, but less favorable tax treatment
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For any person providing services
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For employees or advisors
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Recipient
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Employees satisfying certain working time conditions
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Employees, directors, and consultants
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Only employees
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Employees, directors, and consultants
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Employees, directors, and consultants
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Employees, directors, and consultants
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Exercise price
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Usually at actual market value agreed with HMRC but can be at a discount to the market value (which means the discount is taxable on exercise)
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Can be nominal value
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At least fair market value (FMV) (110 percent of FMV if optionee is > 10 percent shareholder)
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Exercise price typically fair market value (FMV), but may be greater or less (but subject to Section 409A if exercise price is less than FMV)
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N/A
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N/A
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Taxation (grant)
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None
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None
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None
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None (assuming exercise price at least equal to FMV on the date of grant)
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None unless election under IRC 83(b) is made; awardees are generally encouraged (or required) to file an election under IRC 83(b) to be taxed at grant in order to minimize the tax burden
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Income tax on restricted market value (RMV) of the securities (less any amount paid for the securities) as of the date of acquisition. Grantee may also make a 431 election to pay income tax on the unrestricted market value of shares on exercise date (UMV) at acquisition. Different rules will apply if the restrictions are less than five years.
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Taxation (exercise)
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None (assuming exercise price at least equal to the actual market value of the underlying stock on the date of grant and no disqualifying events have occurred)
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Taxable income equal to unrestricted market value of shares on exercise date (UMV) of the securities minus exercise price (assuming a section 431 election has been signed). Taxable income may be subject to withholding on account of income tax and employee and employer NIC under PAYE, if there are arrangements in place for the shares to be transferred or sold.
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Spread is AMT income unless shares sold in year of exercise.
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Spread is compensation income to optionee and deductible expense to company; if optionee is an employee, tax withholding will be required regardless of liquidity of underlying stock.
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N/A
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N/A
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Taxation (sale)
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Qualifying disposition: Capital gains tax payable on extent to which sale price exceeds exercise price (or AMV if granted at a discount), and it exceeds the individual’s unused annual allowance. May qualify for Entrepreneur’s Relief if 24 months have passed from date of grant.
Disqualifying disposition: Capital gains payable on any gain between sales price and UMV on exercise date.
If option exercised and shares sold on same date, no capital gains tax.
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Capital gains payable on any gain between sales price and UMV on exercise date.
If option exercised and shares sold on same date, no capital gains tax.
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Qualifying disposition: Excess of sale proceeds over exercise price is long-term capital gain.
Disqualifying disposition: Lesser of exercise date spread or actual gain on sale is ordinary income. Excess gain is capital gain. Ordinary income is deductible expense to company.
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Excess of sale proceeds over exercise date FMV is capital gain.
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Excess of sale proceeds over vesting date FMV (or grant date FMV if 83(b) election made) is capital gain.
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Any portion of the UMV of the securities that was not subject to income tax on acquisition will be subject to income tax as the securities are sold, unless a 431 election was signed at acquisition. Otherwise capital gains tax is payable
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The area of equity compensation is complex, and so the guidance of an equity compensation specialist is crucial in order to avoid adverse tax consequences for the company and/or your employees.
