Business and Corporate Section Monthly Article

Executive Stock Compensation

Business owners are always interested in attracting and retaining talented people, but often struggle with how to compensate them. Often cash strapped start-ups and small businesses offer stock in lieu of cash hoping that executives will be motivated to work hard and stick around. In principal this is a good idea, but in practice it’s not so simple.

Giving executives stock has several disadvantages. First, stock received in exchange for services is taxed as ordinary income to the executive and is not deductible to the corporation (IRC § 83). Second, giving the employee stock also means giving the executive voting rights that could impede the corporation’s ability to be sold or merged (Cal. Corp. Code § 1300). Third, giving the executive stock gives him or her standing to bring claims against the corporation’s board of directors and its officers for breaches of fiduciary duties and other corporate governance claims. Fourth, giving an executive stock does not guarantee that he or she will do a good job or stick around.   

A corporation offering stock or stock options to its executives should consider doing so through a qualified plan-a plan that qualifies for beneficial tax treatment under the Internal Revenue Code. In addition, all stock compensation should be conditioned on certain vesting requirements and other restrictions. Such vesting requirements and restrictions put limits on the transfer of stock, require ongoing employment, can limit the executive’s involvement in corporate decision making, and ensure that the corporation will retain the stock if the executive ceases to be employed by the corporation. However, the requirements for qualified stock plans and the enforcement of restricted stock plans can be burdensome on start-ups and smaller corporations, not to mention the legal fees involved.

Alternatively, a corporation might consider non-stock compensation, such as profit sharing plans or phantom stock plans. Profit sharing plans eliminate the complication associated with stock plans and is essentially cash compensation based on the corporation’s performance. Phantom stock plans don’t require any cash compensation until exercised, yet incentivize executives in much the same way as offering actual stock without the risks and complications. Any cash compensation paid under profit sharing and phantom stock plans is taxed as ordinary income to the executive and deductible to the corporation when paid, which makes them attractive. Businesses owners should consider all of their options before giving away a piece of their company.

Patrick Monroe, Monroe Law, APC

**This article is intended for informational purposes only and does not constitute legal advice. Any views expressed are those of the author only and not of the SDCBA or its Business & Corporate Law Section.**