Equity compensation planning when markets are in turmoil

An equity compensation plan is a noncash pay arrangement offered by companies to their employees, which provides them compensation aligned with the value of the company. The ownership stakes can include stock options, restricted stock and performance shares. These plans are designed to align the interests of employees with those of the company to incentivize employees to contribute to the company's success.

What happens to equity compensation in a volatile market? 

In periods of growth and expansion, equity compensation arrangements and incentives are attractive to employees and employers alike. However, political uncertainty, tariffs, rising prices and a volatile stock market make an economic slide top of mind for many. How can an equity award retain its attractiveness in a softer economy? Are there equity compensation strategies employers can adopt in times of market volatility? If recession arrives, what can employees do to salvage the equity granted to them in periods of growth? The answer depends on the type of equity arrangement each employee holds and whether their employer will adjust the arrangement to suit the economic climate.

Stock options

How do incentive stock options (ISOs) work?

Incentive stock options (ISOs) are an attractive equity compensation method when prices are rising because employees who hold their stock until the later of two years from the date of grant or one year from the date of exercise (the holding period) are not required to recognize ordinary compensation income on exercise. Instead, income tax is deferred until the eventual sale of the exercised stock, and the shares receive capital gain treatment at that time. However, employees exercising ISOs are required to record an alternative minimum tax (AMT) adjustment related to the “spread” (the fair market value (FMV) of the stock at exercise, less the amount paid to exercise), potentially subjecting them to the AMT in the year of exercise.

When employees believe the value of their exercised stock will continue to increase, AMT may seem like a small price to pay. When employees exercise ISOs during or just before a period of falling share prices, the AMT adjustment and tax deferral appear less attractive. However, employees can minimize the phantom AMT using a disqualifying disposition strategy.

Disqualifying dispositions are any sale of exercised ISO stock before the required holding period. The disqualifying disposition changes the taxation of the income related to the spread. When done in the same taxable year as the exercise, it also removes the requirement to recognize an AMT adjustment. Disqualifying dispositions require the employee disposing of their ISO stock to recognize ordinary compensation income of the spread at exercise or, in the case of depreciated stock, the amount received from the sale of the stock. If the value of the stock falls below the amount paid for the shares, there is no compensation income to report; instead, the sale is reported as a capital loss. When employees receive less value in return for the sale of their stock than the AMT income they would have recognized at exercise, the ability to pay income tax on only the amount received in a disqualifying disposition can be an attractive alternative.

How do nonqualified stock options (NSO’s) work?

The tax treatment of nonqualified stock options (NSOs), those that don’t meet the requirements for ISO treatment, differs. Employees who exercise NSOs are required to recognize ordinary income equal to the FMV of the stock at exercise less the price paid to exercise. Any gain or loss on the sale of the stock post-exercise is subject to capital gain treatment.

Employees holding NSOs can minimize their tax burden by carefully timing the exercise of their options. Exercise prices are set at the grant, and in many cases, the option exercise window may be up to 10 years from the date of the grant. So, periods of volatile prices offer employees the opportunity to wait to exercise until the FMV of the underlying stock is close to their exercise price, reducing their ordinary income tax burden. Employees may also be able to ‘net exercise,’ which limits a direct cash outlay by selling a certain amount of exercised stock to cover the exercise and tax costs. If the stock price of exercised options continues to fall, employees who sell their exercised stock will recognize a capital loss, which nets with their capital gains, and if any remains, $3,000 of capital loss is deductible against their ordinary income each taxable year. 

Option repricing

 What does it mean for options to be underwater?

Options that are ‘underwater,’ i.e., options that have an exercise price greater than the current FMV of the underlying stock, may never make sense for the employee to exercise since the individual could theoretically purchase the stock at a lower value on an open market. Underwater options in a private company may prove too risky to exercise if it is uncertain whether the stock price will ever recover.

What is ‘repricing’ stock options?

Though employees can avoid the negative consequences of underwater options by choosing not to exercise, employers use options to incentivize employees to remain with a company longer. Underwater options no longer hold that incentive. In such situations, employers may consider repricing their options. Repricing can restore the incentive of an equity compensation plan for employees, but it often involves administrative hurdles like rewriting legal documents or obtaining shareholder approval.

The amendment or reissuance of an option agreement to reduce the strike price of options does not have any immediate tax consequences for the employees or employer. But, in both situations, the new exercise price must be equal to or greater than the FMV of the underlying stock at the time of repricing to remain exempt from the deferred compensation rules in section 409A. Extensions of option agreements due to an underwater option strike price are also characterized as the grant of a new option. Any modification or grant of new options must be carefully evaluated per section 409A.

Employers can also cancel their outstanding stock options to replace them with other remuneration. Cancellation of underwater options for cash results in immediate compensation income for the affected employees (and a corresponding deduction for the employer) but doesn’t provide any additional motivation for the employee to remain with the company. Cancellation of stock option agreements to replace them with another form of equity, such as restricted stock, does not require immediate recognition of income for the employees and may restore the retention incentive as well.

Employers concerned about volatile prices and their option agreements’ exercise prices going underwater may wish to consider this when timing their stock option grant issuances. Timing stock option grants and strike prices to correspond with periods of lower stock value can reduce the chance that the options’ exercise price will go underwater and eliminate the potential headaches of undergoing an option repricing plan.

Other compensation plans

Any compensation method tied to the value of a company’s equity may lose its impact during periods of falling prices and market volatility. Restricted stock, restricted stock units, long-term incentive plans, bonus pools and phantom equity plans may be tied to company performance to align executives’ interests with the company’s interests. In addition, other performance goals based on measurement metrics such as EBITDA growth, expansion into new markets, environmental, social and governance (ESG) initiatives or other metrics may become unattainable during the performance period due to external market conditions.

When factors outside of an executive’s control, such as market volatility or a recession, make performance targets impossible to hit, compensation plans may disincentivize recipients to make decisions on a longer-term basis or may make outside opportunities more attractive.

Employers looking to revitalize employee engagement may consider resetting performance metrics in their equity compensation plans or including clauses allowing discretion in target measurement. Instead of targets tied to specific stock prices or equity values, new performance metrics may be better tied to relative growth or events like new product launches designed to incentivize certain behaviors without being outside the employee’s sphere of influence.

In general, amending or canceling and reissuing agreements will not result in new tax consequences for employees or employers, but care must be exercised to examine the latest plan for section 83(b) and section 409A considerations, if applicable.

Adjusting compensation agreements is not an unlimited opportunity. Employers must pay close attention to the consequences of existing employee plans when markets fall. Once the stock has been issued or an 83(b) election has been made, the IRS will only respect rescission within the same tax year. In addition, an agreement may not be canceled if it leaves either party in an altered position from the one they would have been had the original agreement never been made. Hesitation to act may close the window for plan amendment for certain employees, resulting in unintended consequences that will be difficult to correct.

Other considerations

Regardless of market conditions, it’s important for employees to review their overall portfolios on a regular basis, especially when receiving compensation based on their employer’s performance. It’s easy for employees who receive equity compensation to become overweighted in their employer’s stock. When the company is doing well, the employee may be hesitant to dispose of stock they believe will continue to increase in value, and during downturns, they may wish to hold on to that stock in anticipation of a turnaround. Unfortunately, in worst-case scenarios, employees holding most of their wealth or other savings in company stock may be left without a job or a financial buffer when companies fail. Creating a systematic plan for equity compensation grants commensurate with one’s long-term goals—whether to dispose of or hold onto stock while minimizing the tax burden—is in the executive’s best interest.

Employees should also be aware of the ‘fine print’ on their equity awards. Must they sell their restricted stock if they leave the company? Will restricted stock vest upon separation of employment? Is there a period of time in which they must exercise vested options if their employment is terminated? Many option plans use a post-termination exercise period of 90 days, meaning employees must choose to exercise options within three months of ending their employment or lose them entirely. This short period, which is required for ISOs, gives employees minimal time to consider what to do with their vested options if they’re unaware of this clause. When stock prices are unpredictable, the decision making process becomes even more difficult. It’s a good idea for option holders considering leaving their employment or anticipating potential layoffs to plan how and what they’ll exercise.

The considerations around equity compensation are complex, especially when economic instability adds a layer of unpredictability to the analysis. It’s best to involve your tax advisor early on when drafting or modifying an equity compensation plan or making complex decisions about exercising, holding or selling equity.