Equity incentive plans are a powerful tool for encouraging and rewarding a company’s employees and leadership, who may include prospective investors, through different kinds of equity interests and structures. Different structures can present different tax and economic consequences for the company and participants upon grant, vesting, purchase, or later sale.
Closely held businesses vary widely in size, budget, legal and tax structure, sophistication, compensation philosophy, and risk tolerance. Incentive programs therefore also vary widely among closely held and private businesses. Many smaller private businesses prefer simpler, traditional stock incentive options, as opposed to synthetic equity or other complex arrangements.
This blog compares three common alternatives for a small business (here, “Company”): (1) issuing shares as compensation; (2) issuing shares by subscription (new shareholders buying-in at fair market value); and (3) incentive stock option (“ISO”) or nonqualified stock option (“NSO”) alternatives. The following is a brief summary of equity incentive alternatives available to the Company, and the advantages and disadvantages of each.[1]
Issuing Shares by Subscription.
Issuing shares by subscription requires the employee to purchase shares at fair market value.
The advantages of this approach are: (1) the shares are not treated as taxable compensation to the shareholder; (2) the shareholder has purchase price basis in the shares, which could reduce capital gain taxes to shareholder when shares are purchased in the future; (3) the Company receives additional capital in the form of the subscription price; and (4) the shares would be acquired from a C corporation issuer, and therefore eligible for the Code Section 1202 gain exclusion (assuming substantive requirements are met).[2]
There are some disadvantages to issuing shares by subscription. First, a reasonable valuation of the Company is required to ensure that the shares are not purchased at a discount, which would trigger deemed taxable compensation to the shareholder in the amount of any discount. Second, requiring an employee to purchase shares at fair market value can reduce or eliminate the incentive provided by the equity. In some instances, the shareholder may not have sufficient income or assets to make the purchase.
Companies seeking to issue shares via subscription often sell shares on a promissory note and enter into a corresponding employment agreement with the relevant employee. The employment agreement awards a cash bonus each year that happens to equal: (i) the installment payment for the share subscription for the year, plus (ii) the additional income taxes payable by the employee arising from the cash bonus.
This eliminates the financial strain of the share purchase on the shareholder, while also mitigating the tax impact of the bonus. The Company can take a deduction for the full amount of the bonus but receives a partially offsetting capital contribution in the form of receiving a portion of the bonus back as a subscription payment. An additional advantage of this approach is locking-in the value of the shares on the date of subscription, while allowing the employee to pay over the term of the note. This affords the employee the opportunity to fully benefit from the appreciation of the stock value before completely paying for the shares.
Awarding Shares as Compensation.
It is possible for the Company to issue shares to an employee at no cost to the employee. However, this issuance is deemed to be compensation to the employee and will be taxable income to them in the year of issuance. Where the issuance is large, or the company is particularly valuable, this deemed income could result in an unduly onerous tax bill for the employee. While it is possible for the Company to pay a bonus that covers this tax bill, most companies do not have sufficient cash flow to fund the bonus in a single year.
An alternative approach is a “restricted stock award,” where the employee receives shares as compensation over a term of years, with vesting requirements that must be met before additional shares are awarded to the employee. The employee can receive the shares as compensation in the year of vesting or make a Code Section 83(b) election to treat the entire grant as compensation in the year of issuance. It is possible for restrictive stock awards to require payment in connection with the grant. This reduces the number of shares issued as compensation but requires the employee to fund the purchase (implicating the concerns summarized above).
“Restricted Stock Awards” and “Restricted Stock Units” can quickly become complex. The more restrictions, vesting requirements, and alternatives that are included, whether in favor of the Company or the employee, the more likely the incentive plan will be subject to the complex and onerous rules of Code Section 409A. For these reasons, we sometimes recommend a more simplified approach to equity incentives. If you are interested in exploring a robust restricted stock award or unit plan, our executive benefits and compensation team are experts at crafting tailored programs for many business needs.
Stock Option Plans.
There are generally two kinds of stock option plans: ISOs and NSOs. ISOs are most favorable to employees from a tax perspective but are less flexible and do not permit a deduction to the Company except to the extent included in the employee’s gross income. NSOs are immediately deductible to the Company and subject to fewer requirements but result in ordinary income for the employee.
- Advantages. Options are cost-effective as they involve no cash drain (and Company gets a tax deduction when the holder exercises an NSO) and may also offer tax benefits to employees (especially ISOs). Like other equity incentive programs, options incentivize collective employee performance, aligning employee interests with those of shareholders.
- Disadvantages. The tax treatment of stock options is more complicated than a stock purchase arrangement and can be difficult for employees to understand. Unless the company adds individual performance-based vesting criteria, options reward aggregate rather than individual performance. If Company stock does not appreciate, options do not have the same retentive effect as full value awards (like restricted stock awards or units). Similar to a simple share subscription, employees must come up with the money or other consideration to pay to exercise an option. Options are difficult to value.
Additional nuances distinguish the two sub-types of stock options: “NSOs” and “ISOs”.
ISOs are appealing to employees because of their favorable tax treatment, but at the cost of flexibility. IRC Section 422 provides numerous requirements to qualify for ISO treatment. The Code imposes various holding requirements, exercise requirements, plan requirements, exercise price requirements, and term limits – all of which are outside the scope of this blog.
NSOs are stock options that do not satisfy the definition of an ISO under the Code. If an employee receives an NSO with an ascertainable fair market value at the date of grant, the fair market value, minus any purchase price for the option, is ordinary income to the employee at the date of grant. An individual who exercises a non-qualified stock option must pay ordinary income taxes on the excess of the fair market value of the underlying shares on exercise over the exercise price.
Code Section 409A applies to NSOs, and it is best practice to receive a third-party appraisal of the Company prior to issuance of the option, which can be very costly. If the exercise price under the NSO plan is equal to the fair market value of the underlying share on the grant date, Section 409A generally does not apply. Still, it is necessary to obtain an appraisal to substantiate this exemption. Similarly, a change to an NSO plan later could re-implicate Section 409A and its requirements.
Conclusion:
Equity incentive plans come in many shapes and sizes. They vary in economics, flexibility, legal and tax advantages. Whether and which plan works best may depend on the Company and its participants’ particular activities, goals, tax status, legal relationships, and other facts and circumstances. In choosing an equity incentive program, also consider which alternatives produce the best cash flow results to the Company and its employees.
Companies and counsel should include accounting in their planning conversations to evaluate cash flow available to fund equity grants and potential deductions available for compensation (deemed or actual), and timing implications of various structures, sales, and elections.
[1] This blog does not analyze the entire universe of equity plans available but instead focuses on some of the more common alternatives. It is intended as a summary and not an exhaustive analysis. Changes in tax law may affect this analysis.
[2] As discussed separately, Section 70431 of the One Big Beautiful Bill Act (OBBBA) makes the following substantive changes to IRC § 1202, effective for stock originally issued after July 4, 2025: (1) three-tiered scheme by softening holding period requirement for escalating exclusion rates (at 50, 75, and 100%) after 3, 4, and 5 years; (2) raising 1202(b)(1) cap from 10M to 15M; (3) expanding 1202(d)(1) gross asset ceiling from 50M to 75M; and (4) indexing caps for inflation starting in 2027. See One Big Beautiful Bill Act, Pub. L. No. 119-21, § 70431, 139 Stat. 1320 (2025); I.R.C. § 1202(a), (b)(1), (d)(1) (2025). Mechanical differences in these alternatives (e.g., vesting, purchase), will affect the determination of original issuance and the relevant holding period for purposes of IRC 1202.
