How to Draft Stock Option Plans for Employees


Stock option plans for employees are an effective strategy to maintain employee satisfaction and retention while preserving a startup’s precious cash funds. Employers can issue restricted stock to employees as well as permit employees to purchase stock under a stock purchase plan. Stock option plans (employee stock options, if the startup is a corporation; or profit interest, if the startup is an LLC) must comply with federal and state tax laws to be mutually advantageous to the company and the employee. There are many requirements, including that startups must properly design their incentive plans to avoid expensive adverse tax consequences for either the startup or employee. The employment attorneys at Startup Company Counsel understand the tax implications of stock option plans and can help your startup institute a stock option plan for employees that abides by California law and retains the employees without incurring adverse tax consequences for the startup or employee.

Corporations – Stock Options

When a corporation wants to increase employee compensation and a simple pay raise is either insufficient to compensate the employee or compromises valuable cash funds, the corporation creates an “employee stock option program”.  The stock option program grants the employee the opportunity to purchase stock in the company at a specified, determined price, during a specified timeframe. The viability of the stock option plan depends on upon the tax treatment of the plan. In addition, the shareholders must approve the stock option plan before it can go into effect.

The Internal Revenue Service (IRS) requires the stock option plan to satisfy many conditions to qualify as a stock option plan for employees.  For purposes of the IRS and the California Franchise and Tax Board (FTB), there are two types of stock options: statutory and non-statutory. The IRS and FTB treat statutory options differently from non-statutory options.  A statutory option must meet the requirements of IRS sections 421-424; these sections determine the personal income tax implications for the employee and the corporation.  If the employee compensation plan meets the IRS requirements, then the employee realizes no income from the transfer of the share from the corporation to the employee. The corporation is not permitted to take a deduction as a business expense for the stock transfer.  In addition, the IRS requires a holding period before the employee exercises the option. To qualify as a statutory transfer, the employee must hold the option for two years and then must hold the shares, once purchased and transferred, for one year before disposing of them. Moreover, the individual to whom the employer conveyed the option must be employed and must continue to be employed by the corporation within three months before exercising the option.  Failure to observe these qualifications results in a taxable event for the shareholder because the IRS will deem the transaction to be non-statutory.

The above-mentioned IRS rules are only a few examples of the rules related to deeming a stock option statutory or non-statutory. However, the employer and employee must observe additional rules promulgated by the IRS and the FTB. The FTB treats employee income differently depending upon whether the employee is a state resident or whether the employee primarily performed the work within California as a non-resident. California defers, including the exercise of the stock option in an employee’s gross income, until the employee disposes of the option or the shares of the corporation acquired by the employee’s exercise of the option.  The IRS excludes employees from participating in the stock option plan that holds more than ten percent in the company as well as those employees classified by the IRS as “highly compensated” employees.  Furthermore, the IRS requires the stock prices to be no less than 85% of the fair market value of the share price and imposes time limitations upon employees regarding exercise of the options granted by the employer.

When a corporation wants to create a stock option plan for employees, it needs to take many steps and precautions.  The employment attorneys at Startup Company Counsel can help you and your corporation draft stock option plans that will adhere to all IRS and FTB regulations.

LLC – Profit Interest

When a limited liability company wants to increase employee compensation without further diminishing their cash funds, a limited liability company creates an equity option plan that allows the sharing of profits interests.  Issuance of a profits interests entitles the recipient (such as an employee) a right to percentage of future appreciation of the business.  Profits interests can be a useful mechanism for incentivizing a key employee with potential for increased compensation.  Similar to a corporation granting a stock option plan to an employee, a limited liability company’s issuance of profits interests has tax ramifications, but there are some key differences.  For example, an employee receiving a profits interest should consider an immediate 83(b) election, as it may be wise to elect to immediately pay any taxation on a lower valued profits interests as opposed to a higher value profits interests that may appreciate over time.  Additionally, an employee with a profits interest will receive a K-1 statement attributing their respective share of ownership and he or she will pay taxes on the amount of distributions made to the employee. It is important to consult with a Startup Company Counsel’s California lawyer to understand the potential tax ramifications of the profits interest, which include the examples mentioned above and other tax ramifications.

California Employment Attorneys Discuss Equity Incentive Plans

In order to have a successful equity incentive plan for employees, employers must institute their program properly.  Failure to do so will not only be costly to the employer and employee, but could put strain on the relationship or potentially on the business.  Startup Company Counsel’s California lawyers will work closely with employers to create an equity incentive plan for employees that meets IRS and FTB standards. Call the experienced employment attorneys at Startup Company Counsel at 408-441-7500 or email them today.

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