Legal requirements for equity compensation
In this article, we will examine the general terms of equity compensation and its legal requirements.
Although the term equity is often used interchangeably with stocks, equity compensation differs because it does not require a stock purchase but instead grants an investor ownership of a company. When an employer grants an employee who has reached a certain tenure level, the equity or stock option confers owner-like rights over publicly-traded company shares. In this article, we will examine the general terms of equity compensation and its legal requirements.
Equity compensation and legal requirements
Employee equity compensation plans are becoming more popular to attract and retain employees. Existing employers can also use stock option plans to grant ownership interests in the company, which can help to attract investors or entrepreneurs seeking to start a new business. Companies have also used them to raise capital from outside investors. The legal requirements for equity compensations and financial disclosure requirements to investors have changed over time. We will review these requirements in this article as well. Let us get started!
What is equity compensation?
Any form of compensation or remuneration that does not consist of cash. In particular, it can be any time an employer provides its employees with rights to economic interests in a company, particularly stock ownership, stock purchase rights, and stock purchase plans. Employers choose to use this as a form of paying their employees because it can be easily designed to align employees’ interests with the company’s success.
Types of equity compensation
There are many different ways to compensate employees with equity. They can be as simple as tying an equity bonus to the amount of profit earned by the company or as complex as a stock option. Following are some of the main types of equity compensation:
- Stock options – A stock option is the right to buy shares of the company’s stock at a predetermined price within a set period. The amount of the option depends on several factors and usually represents a non-cash payment to the employee.
- Restricted stock – A restricted stock award is the most common form of equity compensation. An employee is awarded shares or other ownership interests in the company upon reaching certain milestones in their employment.
- Equity bonus – An equity bonus is a form of non-cash compensation often issued in times of extreme success. This is usually used to motivate workers to do their best, or in some cases, the company cannot give them cash bonuses due to financial constraints.
- Stock purchase plan – A stock purchase plan allows employees to acquire shares for a set price and time frame. These plans typically involve an employee investing in the company with every paycheck they receive.
- Stock appreciation rights – Stock appreciation rights are a popular form of equity compensation used for companies with a long history of success and market growth. These rights grant an employee the option to buy additional shares at a predetermined price over a set time.
- Phantom stock – Phantom stock is a form of compensation that isn’t issued and traded on the open market. Instead, phantom stock is used to incentivize employees by giving them an interest in its success. This type of stock is usually granted quarterly and comes with extra benefits than normal retirement benefits.
Pros and cons of equity compensation
As a means of motivating employees and incentivizing them to do their job well and effectively, equity compensation has been extremely effective. However, in modern-day society, the need for companies to compete against each other is more important than ever before. Therefore, it has advantages as well as disadvantages that are discussed as follows:
- It can help align the interests between employees and the company’s success. This aspect is especially important since many employers are motivated by greed, not by anything else.
- It creates a sense of ownership over the business, which can help build motivation among workers who feel they influence their workplace’s success.
- The costs of these are lower than those related to cash bonuses or other methods of paying employees, which can help alleviate the financial burden on employers.
- It is widely accepted among employers, workers, and investors that this can help investors make more money in the long run than if they were to invest in stocks through other methods.
- The risk of incurring losses from failed investments is high since many companies fail during their initial public offerings and are forced to close their doors.
- There is no guarantee that equity will payout because companies can go bankrupt or have bad stock prices overall.
- It has a longer time horizon since it could take years for the value of the stock to reflect its true worth. This means that employees may have to wait long periods before seeing any financial reward.
- The risks associated with this can be higher than those related to cash compensation, as an employee can lose their job in addition to their investment in the company.
Thus, the above-mentioned pros and cons of equity compensation can be considered the main reasons this form of payment is so popular among employers who do their best to attract, motivate, and retain their employees.
Why follow legal considerations while issuing equity compensation?
Issuing stock options to employees can be a good way to motivate the workforce. However, there are legal considerations that companies need to follow before issuing such incentives and other forms of equity compensation. Since equity is usually considered property by both federal and state law, many legal aspects need to be considered for businesses to issue stock-based incentives. Here are legal requirements to keep in mind while issuing equity compensation:
- Companies can be sued and ordered to pay high penalties if they are deemed to have failed in the area of equity compensation.
- It can lead to important tax consequences for both employers and their workers.
- Companies need to assign the right value to equity compensation to avoid further complications down the line.
To avoid any legal complications, all companies need to work with experts knowledgeable in this and who can provide assistance and guidance when issuing stock-based incentives.
Legal and Tax considerations before issuing equity compensation
It is crucial to understand the legal, tax, and SEC consequences before issuing equity compensation. Here are some of the legal and tax consequences to consider before issuing equity compensation:
- Legal considerations – The laws have wide-ranging implications for employers, and they need to understand every aspect of the law governing this type of payment. To avoid any legal complications, all companies need to be aware of the legal compliance requirements for issuing equity compensation for both employers and employees.
- Security laws – Companies need to follow the securities laws governing their issuance, as failing to do so can lead to harsh consequences. Here are three primary security laws that all companies need to be aware of and comply with when issuing them:
- No “sale” – Stock ownership is a private matter, and any company issuing it to employees must ensure that the issuance and trading of stock are not treated as a sale.
- Section 4(2) or Regulation D – It allows an issuer to sell securities in a “private placement” without registration, subject to a limit on the number of securities.
- Rule 701 – It enables private companies to issue securities as part of employee and officer compensation without complying with federal securities registration requirements.
- Corporate laws – It is monitored under federal and state corporate laws, handled by the Securities and Exchange Commission (SEC) and the states’ corporate registrations departments. Companies need to be clear about the laws governing equity compensation and comply with every aspect of the regulations. Hence, all companies need to work with experts knowledgeable in this, who are mandated by the law, and who can provide assistance and guidance when issuing stock-based incentives.
- Tax considerations – Once companies engage in issuing this, they need to be aware that certain tax implications are involved with this type of payment. Following are the major tax considerations:
- Ordinary income and capital gains – Companies need to be clear about the capital gains and ordinary income tax implications when issuing equity compensation. If employees are given options to sell their stock in the future at a predetermined price, they would have to pay taxes on the gain before receiving this payout.
- Incentive stock – Companies need to follow rules that government incentives are issued to avoid any complications arising from this type of way of paying employees. Since state and federal governments regulate incentive programs, they need to be aware of the regulations and rules that govern such programs to avoid unnecessary tax implications by not following them.
- Alternative minimum tax (AMT) – Companies need to be aware of the rules that govern alternative minimum tax. The minimum tax applies when calculating the taxes paid by a taxpayer regardless of how many deductions or credits the filer can claim.
- Section 83b elections – As mentioned above, businesses need to be aware that Section 83b of the Internal Revenue Code could be applicable when issuing equity compensation. It gives the possibility to pay taxes on the total market value of the restricted stock at the time of the granting.
- Section 1202 preferential tax treatment for “Qualified Small Businesses” – It permits individuals to avoid paying tax on up to 100% of taxable gain identified on the sale of qualifying small business corporation stock.
Equity compensation tax advantages
If certain requirements are met, tax advantages might be available to issuers and recipients of equity compensation. It is important for companies to be clear about the tax considerations when issuing stock-based incentives and to understand all the implications of failing to follow them.
Why is withholding tax treatment required for the equity compensation?
Withholding tax treatment is required for it since issuers are considered employers. Withholding of tax means that the compensation would be withheld from the employee’s pay. The reason behind this requirement is that when the employees are paid, they need to get their monthly or quarterly tax deducted for their company and income taxes for them. This ensures that the employees get all the taxes they owe without worrying about it. In the case of equity compensation, the amount is withheld from the employees’ paycheck itself, and then, further taxes are to be paid by them at the end of the year. This protects them from any complications.
409a Valuation for FMV
Issuers of this should be aware of 409a fair market value valuations since it is a law requirement. The reason behind this requirement is that the issuers must comply with the tax code by issuing equity compensation by the 409a valuation rules. These rules govern fair market valuations concerning stock options, restricted stock, and other equity compensation gifts. When 409A is followed, it can protect the taxpayers from any complications related to it.
When does Equity compensation require registrations?
Issuers of equity compensation should be aware of the state laws, SEC regulations, and other federal provisions that govern when they need to register their securities. This is important since it will help them file the required information with the state and federal securities commissions. Depending on when an equity compensation is issued and whether it requires registrations, the issuers might be required to file notices and forms needed by the agencies.
Consideration to register equity compensation
Issuers of equity compensation need to be aware of the considerations when not filing for registrations. This is because a failure to file for the required registrations can cause them to incur unnecessary legal and tax implications. Equity compensation can result in additional liabilities and a complete loss of gain on stock options and restricted stock if no filings are made before the employees exercise their rights to the equity compensation. Thus, issuers should be aware of the rules and regulations that govern the offering and distribution of equity compensation to protect themselves from any concerns.
Why choose Eqvista as the best equity management software?
Equity compensation is one of the common ways employers offer employees stock options and restricted stock awards. To comply with the IRS rules, companies should be aware of the federal and state laws, including the records required to be kept in case of any legal concerns. They need to understand how to protect themselves from any complications because of issuing equity compensation. Eqvista can help you with your company’s equity management! Get in touch with us to learn more about our cap table management software. Also, we offer 409A valuations for your business.