Using stock-based compensation plans.

Stock-based compensation plans offer an excellent way for companies to reward key executives with tax-deferred compensation without running afoul of the nondiscrimination rules associated with retirement plans. They are particularly well-suited for fast-growing companies whose stock prices are increasing rapidly. By using stock-based compensation, cash-poor companies with lots of potential can attract and retain key employees through the promise of company stock or stock options.

There are many different types of stock-based compensation plans, e.g., nonqualified stock options, incentive stock options (ISOs), restricted stock grants, stock appreciation rights (SARs) or performance share plans. From a tax perspective, the two best plans are ISO plans and restricted stock plans.

ISO plans are plans specifically qualified under the Internal Revenue Code that grant eligible employees options permitting them to purchase company stock at a stated price within a set amount of time. So long as these plans meet certain requirements, the employees granted options under these plans may defer taxes paid on the income associated with the purchase of any optioned stock until the date any stock purchased under the plan is sold and, when the stock is sold, may treat any gain in the value of the stock purchased as a long-term capital gain, if the stock has not been sold within two years after the stock options were granted. In order to receive this favorable treatment, the ISO plan must receive shareholder approval within one year before or after the corporation adopts the plan; provide that the options issued under the plan be granted within 10 years of the earlier of the date of plan adoption or shareholder approval, with no options granted under the plan exercisable after 10 years following the options grant, require that the option price equal or exceed the stock's fair market value at the time the option is granted; and require that any employees granted the options exercise them while employed by the company or within three months after termination. An unexercised ISO must also not be transferable unless the employee issued the option dies.

Restricted stock grants are plans under which each eligible employee is granted a specific number of shares that the company can rescind within a specified period if the employee does not continue his employment throughout the specified period. The employee pays ordinary income taxes on the stock's value at the time the company's right to forfeiture expires. The company is allowed a tax deduction equal to the amount of ordinary income realized by the employee, but the company is only required to charge a loss to its accounting books of the stocks value at the time it is granted to the employee. If the value of the stock has increased between the date the stock is granted and the date it is vested, the company will have tax losses to reduce its taxable income, of which only a portion will show up as a loss on its income statement. This feature makes restricted stock grants excellent for public companies or companies planning initial public offerings.