Fall 2016: Concepts in Stock Based Compensation

By Robert Stankus

The use of stock or equity based incentive as a form and component of compensation for executives and nonexecutive personnel has become fairly common over the years. In the context of income and support as a marital matter, sifting through compensation tranches necessitates an understanding of the underlying form and variables included. 

This article provides an overview of the common types of individual equity compensation plans to help identify economic and financial considerations for a client and counsel in a divorce. The types of plans we will cover here are: (1) stock options, (2) restricted stock units and restricted stock awards, (3) stock appreciation rights, and (4) phantom stock.

Each type of plan typically will include many variables and considerations that must be carefully reviewed that ultimately impact price, timing terms and recognition for taxation.

A brief overview of key concepts for each also serves to help define their differences:

Stock options – These provide employees the right to buy a number of shares at a predetermined price  (regardless of the fair market value of the stock) for a defined period into the future, at a set price known as the “strike price,” and most often with a vesting period while in continuation of service as an employee.

Within the framework of stock options there are two general classifications which the tax code recognizes and these are either  “qualified” or  “nonqualified”. The tax treatment of these classifications differs significantly when valuing stock options.

Qualified stock options, also known as Incentive Stock Options (ISO’s), are the most common form (in accordance with statutory limits) that qualifies for special tax treatment, hence the “qualified” designation. Reporting and tax characteristics of these options include:

          • The grant is not a taxable event (i.e., no compensation is reported.)

          • No taxable event upon exercise and not sold although an Alternative Minimum Tax “AMT” trigger may be affected.

          • When sold the amount is reported and a taxable event is triggered either as ordinary income or as tax advantaged long-term capital gain if held for 12 months and two years past grant date.

Non-qualified stock options may be granted in unlimited amounts with the following characteristics:

          • The grant is not a taxable event.

          • Upon exercise the bargain element (the spread between exercise price and market price) if any, is reported as compensation and taxed at ordinary income rates.

          • When subsequently sold another taxable event occurs on further gain or loss at either short or long-term capital gain rates as determined by holding period.

Restricted stock units (RSU’s) – Restricted stock units are a promise made to an employee by an employer to grant a given number of shares of the company's stock to the employee, usually granted based on a vesting schedule. An RSU is a grant valued in terms of company stock even though no stock is issued at the time of the grant. When the recipient meets the vesting requirements, which also may be tied to performance, the company then distributes the shares or the cash equivalent value if the plan allows for cash instead of the shares, to the recipient.

            • The grant of an RSU is not a taxable event.

            • Upon full vesting the RSUs are reported and taxed as ordinary income as of the date they become fully vested, using the fair market value of the shares on the date of vesting. 

Restricted stock awards - Are similar to RSUs in many ways, but have some unique differences.

Restricted stock awards come with voting rights immediately because the employee actually owns the stock the moment the award is granted. This is in contrast to RSUs, which represent the right to stock, as opposed to owning the stock but with restrictions. Also, restricted stock awards cannot be redeemed for cash, as some RSUs can be.

            • The tax treatment of restricted stock awards comes down to a choice by the employee. IRS code Section 83(b), allows restricted stock award holders to pay the ordinary income tax based on the fair market value of the stock on the day it is granted. This feature is beneficial to many highly compensated executives because it provides them with greater choice in their tax planning in instances where the long-term capital gain treatment is permitted. There is some risk to this if the company fails prior to the stock becoming fully vested.

Restricted stock plans can provide employees the option to purchase the shares at fair market value or a discount, or may receive the shares at no cost.

Phantom Stock and Stock Appreciation Rights – Phantom Stock and Stock Appreciation Rights (SAR’s) plans are conceptually similar. The main characteristic of these plans is the fact that bonus plans do not provide a grant of stock but rather a right to receive an award based on the value of the company’s stock. The value of these plans is typically measured based on an increase of value to be paid out at the end of a specified time period. This often involves a triggering event such as a sale or liquidation of the company.

            • Only when a payout is made is the value of the award reported as compensation and is taxed as ordinary income to the employee.

Because SARs and phantom plans are essentially cash bonuses, companies need to figure out how to pay for them. Even if awards are paid out in shares, employees will want to sell the shares, at least in sufficient amounts to pay their taxes. Some phantom plans condition the receipt of the award on meeting performance objectives, referred to as "performance units”.

The overview above provides a basic understanding of the attributes associated with an income stream that ultimately becomes compensation economics. This provides for appropriately identifying tranches of prior, present and future amounts of that income in developing a support calculation. Ultimately the present and future income is the primary objective of the analysis. Unvested/restricted positions therefore carry the weight of risk about time and the presumed company’s continued upside in value and part of the value of the granted position at a particular date.

Remember to keep in mind that if the trading value of the stock is higher than the exercise price the option is considered to be “in the money”, thus creating the potential to earn a gain on the transaction. In contrast if the stock is priced below the exercise amount the option is considered out of the money whereby no profit is likely to be made if transacted. Even though at that time no financial gain is available to be made it is fundamentally important to understand that options, by their very nature as a financial instrument have a value, and that value can be measured by an option pricing model computation.

Understanding the base concepts above will surely help in properly determining the particulars of each individual incentive compensation form in this complex area and understand if further assistance from a financial perspective is needed.


Robert Stankus is a Director in the Forensic, Litigation, and Valuation Services Group of CBIZ Tofias with a practice focus of litigation support, business valuation, financial damages consulting and forensic accounting. Bob has testified and is qualified as an expert witness in the United States District Court and the Probate and Family Court in the Commonwealth of Massachusetts.