I. INTRODUCTION

Stock based compensation has become the hallmark of the new economy. Once a minor aspect of an executive's overall compensation package, the new economy has become accustom to seeing CEOs of well-established public companies and newly IPOed companies earn tens of millions of dollars from their equity-based compensation.

Equity-based compensation takes many forms, such as stock options, restricted stock, phantom stock and certain elements of deferred compensation. Although each particular instrument functions differently, they all have one element in common, the ultimate value of each instrument is derived from the value of the equity security underlying it, in most cases the common stock of the employer.

In the new economy equity-based compensation is utilized by all types of companies, in all types of industries and for a variety of reasons. Generally, equity-based compensation is used as a means to attract, retain and motivate employees, directors, independent contractors and other service providers. It is also used as currency in lieu of cash compensation. Equity-based compensation provides performance based incentives which have the potential to align the interests of the company's management, employees and strategic partners with those of the company's shareholders.

The multitude of "terms of art" surrounding equity-based compensation and the complex interaction with tax, securities, general corporate and employment laws and accounting rules makes this topic a bit confusing. In fact, there are essentially two forms of equity-based compensation: (i) compensation which results in the transfer of shares of stock and (ii) compensation which results in the transfer of cash in an amount which is measured by some relationship to the value of the employer's stock.

At its core, equity-based compensation arrangements are no more and no less than basic contractual relationships between the employer-company and its employee-service providers. It is the mutual exchange of promises. As such, employers and employee-service providers are free to negociate terms, conditions and covenants as they see fit. However, such negotiations will, to a certain extent, be driven by the effects of the regulatory regimes covering such instruments.

II. STOCK OPTIONS

In its most simplistic form, a stock option gives the recipient a legally enforceable right to purchase employer stock in the future at a predetermined purchase price (the "exercise price"). However, the employer's obligation to sell such stock usually is conditioned upon the recipient satisfying certain vesting conditions such as remaining employed for a certain period and/or meeting certain performance goals. Furthermore, the employer's obligation to sell could be made contingent upon certain covenants (e.g. a covenant not to compete). These conditions and covenants are usually unilaterally established by the employer, but in some cases are negotiated on an individual basis.

Generally, there are three important events and/or dates in the operation of a stock option. First is the grant date. This is the date on which the employer informs the recipient of the terms and conditions of the award. Second, the vesting date or dates represents the date or dates on which the recipient becomes entitled to exercise the stock option or portion thereof. For example, in regards to a performance based stock option, the option vests in whole or in part upon the satisfaction of certain pre-established goals. In regards to an option which vests pursuant to a service requirement, there are two methodologies; gradual step vesting and cliff vesting. Under gradual step vesting, the option vests and becomes exercisable by the recipient in segments over time, such as 20% per year over 5 years. Under cliff vesting, the recipient vests in the entire amount at one time, such as 100% vesting upon the completion of 5 years of service. Third, the exercise date is the date when the recipient exercises or requires the employer to perform under the stock option.

The vast majority of stock options currently granted operate by fixing the exercise price as of the date of grant, so that future increases in the value of the underlying stock are captured for the benefit of the recipient. If structured correctly, stock options granted with a fair market value exercise price will have no income statement effect to the employer/issuer for financial accounting purposes.

As discussed below, stock options are broken down into two distinctive types: Incentive Stock Options ("ISOs") and Non-Qualified Stock Options ("NQSOs"). Although, the instruments themselves are basically identical, their treatment under the tax code is somewhat different.

A. ISOs

(i) Statutory Requirements

ISOs must be granted pursuant to a written plan which meets the requirements of Section 422 of the Internal Revenue Code of 1986, as amended (the "Code"). Section 422 of the Code requires, among other things, that:

* The exercise price of an ISO must be no less than the fair market value of the underlying stock on the date of grant (or, if applicable, 110% of the stock's fair market value for a 10% or more shareholder).

* The aggregate fair market value of the underlying stock with respect to which ISOs become exercisable for the first time during any calendar year may not exceed $100,000.

* The term of an ISO can not exceed ten years (or, if applicable, five years for a 10% or more shareholder).

* ISOs can only be granted to officers and employees of the issuer (inculding its parent and subsidiaries).

* An ISO can not be exercised beyond three months from the date of termination of employment (or one year in the event of death or disability).

* Each ISO must state that it is nontransferable other than by will or under the law of decent and distribution.

* Employers can add additional restrictions and conditions to ISOs that are not inconsistent with the Code's general requirements.

* The written stock option plan must be approved by the shareholders of the company within twelve months of its adoption by the company's board of directors.

* The stock option plan can not extend beyond ten years.

* The plan must specify the class or classes of employees eligible to participate and the aggregate number of shares available under the plan.
* The stock option plan can provide for the ability to grant ISOs as well as other types of equity compensation, such as NQSOs (described below).

(ii) Taxation

* Upon the granting of an ISO, there are no tax consequences to either the employee or employer.

* Upon the vesting of an ISO, there are no tax consequences to either the employee or employer.

* Upon the exercise of an ISO, no income will be recognized by the employee for ordinary income tax purposes (although the difference between the exercise price and the fair market value of the underlying stock may trigger alternative minimum tax liability) and the employer will not be entitled to a tax deduction. The employee takes possession of the stock with a tax basis equal to the exercise price paid and the holding period for capital gain/loss purposes begins.

* Upon a "disqualifying disposition" of stock acquired pursuant to the exercise of an ISO, the employee will recognize ordinary income in an amount equal to the lessor of (a) the difference between the fair market value of the stock received upon the exercise and the ISO's exercise price and (b) the difference between the amount realized upon the disposition and the exercise price. Any excess gain will be taxed at capital gain rates (assuming that the stock was held as a capital asset) which depends upon the actual holding period associated with the stock. Furthermore, the employer will be entitled to a tax deduction equal to the amount of ordinary income recognized by the employee. A "disqualifying disposition" occurs when stock acquired pursuant to the exercise of an ISO is sold or otherwise disposed of within two years of the ISO's date of grant or one year from the date of exercise.

* Upon the disposition of stock acquired pursuant to the exercise of an ISO, other than a "disqualifying disposition", the employee will be taxed at long-term capital gain (loss) rates (assuming that the stock was held as a capital asset) in the amount equal to the difference between the amount realized upon the disposition and the employee's tax basis in the stock, which is most likely equal to the exercise price. Accordingly, stock held beyond the "disqualifying disposition" holding period will avoid being taxed at ordinary income tax rates and will preclude the employer from taking a tax deduction.

(iii) Discussion

ISOs offer two major advantages and one major disadvantage. First, ISO's effectively defer the recognition of taxable income until the stock received pursuant to its exercise is actually sold. Second, assuming that a "disqualifying disposition" does not occur, the appreciation of the underlying stock is taxed at long-term capital gain rates upon the ultimate sale of the stock.

The major disadvantage of ISOs is the employer's loss of the tax deduction. Other minor disadvantages stem from the inflexibility of the statutory requirements and the possible application of alternative minimum tax on individual taxpayers. Under certain circumstances recipients of ISOs are forced to conduct disqualifying dispositions in order to avoid triggering the alternative minimum tax.

B. NQSOs

(i) Statutory Requirements

Generally, stock options which fail to qualify as ISOs (see the statutory requirements above) are NQSOs. NQSOs are much more flexible than ISOs because the Code does not impose requirements such as minimum exercise price, specific terms, duration and the like. NQSOs are taxed pursuant to Code Section 83 as property transferred in connection with the performance of services.

(ii) Taxation

Assuming that the NQSOs do not have a readily ascertainable fair market value at the date of grant (e.g., options traded on a national exchange), which most do not, NQSOs are taxed as follows:

* Upon the granting of a NQSO, there are no tax consequences to either the recipient or employer.

* Upon the exercise of a NQSO, the recipient of the stock option will generally realize, as ordinary income, an amount equal to the difference between the fair market value of the underlying shares and the exercise price. For tax purposes, the employer will be entitled to a compensation deduction equal to the amount of ordinary income recognized by the recipient.

* Upon the sale of the acquired shares, the recipient of the stock option/seller will be taxed at capital gain (or loss) rates (assuming the stock was held as a capital asset) which depends upon the actual holding period of the stock.

(iii) Discussion

The major advantage of NQSOs over ISOs is the flexibility in drafting and designing the specific instruments. Although the flexibility inherit in a NQSO allows instruments to be crafted to largely duplicate the preferential tax treatment afforded ISOs, accounting issues become more complex and problematic. In any case, both public and private companies can utilize NQSOs to accomplish a wide variety of corporate goals.

(iv) Transferability

Unlike ISOs, NQSOs are generally transferable and certain recipients of NQSOs may realize estate and gift tax savings by transferring stock options to family members, trusts or family partnerships. It is important to understand that NQSOs so transferred do not alter their taxability for income tax purposes. Under the assignment of income doctrine, the transferor remains liable for the ordinary income generated upon the exercise of the stock option. For example, if a NQSO is so transferred, the transferor will recognize ordinary income and become liable for the corresponding income tax liability upon the exercise by the transferee equal to the difference between the fair market value of the underlying stock and the exercise price. However, gain or loss recognized upon the subsequent disposition of the stock by the transferee will be taxable to the transferee as capital gain (or loss) (assuming that the stock was held as a capital asset.)

Gift taxes would be imposed on the fair market value of the stock option transferred, subject to the application of the unified credit and annual gift exclusion. However, savings of gift and estate taxes may be realized to the extent that the gift taxes on the value of the stock option are less than the gift or estate taxes due if the stock option was held, exercised by the recipient and then transferred by gift or will to the transferee.

(v) Reload Options

Reload options are used to ease the cash burden on recipients who exercise their stock options by tending previously owned shares of the employer's stock in lieu of cash. The use of previously owned shares as a means to exercise stock options serves to reduce the recipient's overall holdings of employer stock which may be inconsistent with the employer's goal of aligning the interests of the recipient with those of the employer and its shareholders. Reload options remedy this problem by giving the recipient a new stock option upon the exercise of an existing stock option. The new stock option is for the same number of shares actually tendered in the exercise and its exercise price is set equal to the fair market value of the underlying stock on the date the existing stock option was exercised. The new stock option's term will be equal to the term remaining on the existing stock option. In effect, reload options compensate recipients for the lost opportunity to realize appreciation on the shares which were utilized to exercise the existing stock option.

Generally, reload options are taxed like ordinary NQSOs. Accordingly, there are no tax consequences upon the grant, but the recipient will recognize ordinary income upon the exercise of either the existing NQSO or the reload option. Likewise, the employer will recognize a compensation deduction to the extent that the recipient recognizes ordinary income.

C. General Provisions Applicable to Both ISOs and NQSOs

(i) Acceleration of Vesting and Extension of the Exercisabilty Period in the Event of a Change in Control of the Employer

To provide that certain recipients are protected in the event of a change in control of the employer, many stock options, including ISOs and NQSOs, provide for the automatic acceleration of vesting and an extended exercisability period upon the occurrence of a change in control. These provisions fall into two categories: single triggers and double triggers.

A single trigger (or single event) change in control provision becomes effective upon a change in control. A double trigger (or multiple events) change in control provision only becomes effective upon the occurrence of multiple events. For example, a typical double trigger occurs where a recipient's service is involuntarily or constructively terminated within a specified period following (or immediately preceding) a change in control of the employer. Generally, double triggers are more common because they do not provide windfall benefits for recipients who remain in the service of the employer's successor.

The most critical element of a change in control provision is the definition of what constitutes a change in control. It is imperative that the provision not be triggered accidentally. Furthermore, the provision must be flexible enough to allow for certain transactions which the employer's board of directors deems appropriate while also acting to protect the employer from possible unwanted and hostile advances. In the private company context this becomes extremely important where an individual or group of individuals control the company but desire the flexibility to associate with strategic partners and dilute their ownership down to levels below 50% of the voting stock without triggering the change in control provision.

In regards to ISOs, an accelerated vesting feature, such as a change in control provision, may cause an ISO to violate the $100,000 maximum calendar year vesting limitation, as indicated above. However, in the event that more than $100,000 worth of ISOs do become vested in a single calendar year, the excess becomes NQSOs for tax purposes. Additionally, the extension of the exercisabilty period beyond three months from the date that an employee terminates employment will not violate the requirements of an ISO, however, ISOs actually exercised beyond the permissible three month period will be taxed as NQSOs.

(ii) Acceleration of Vesting and Extension of Exercisabilty Period in the Event of Death, Disability and Retirement

Similar to the change in control provision above, the vesting and exercisabiliy provisions of either an ISO or NQSO can be automatically accelerated and/or extended upon the occurrence of the death, disability or retirement of the recipient. The definitions of disability and retirement are extremely important in implementing such a feature. For example, if the term retirement is too broadly defined, a recipient who receives a stock option grant with a long-term vesting schedule could prematurely retire under the definition and qualify for accelerated vesting. Careful drafting will avoid this and similar situations.

In regards to ISOs, an accelerated vesting provision may cause an ISO to violate the $100,000 maximum calendar year vesting limitation, as indicated above. However, in such event, the excess shall become NQSOs for tax purposes. Additionally, the extension of the exercisabilty period beyond three months from the date that the employee terminates employment (or one year for purposes of death or disability) will not violate the requirements of an ISO; however, ISOs actually exercised beyond the permissible period will be taxed as if they were NQSOs.

(iii) Performance Based Options and Accelerated Vesting

In some instances the employer may wish to establish performance based vesting criteria whereby the recipient becomes vested in the stock option, either ISO or NQSO, based solely upon achieving certain objective performance goals such as levels of sales, gross profit, return on equity, and the like. The main disadvantage of establishing stock options which vest solely based upon achieving performance goals is that such stock options will require variable plan accounting treatment and result in the recognition of expenses for financial accounting purposes, which is undesirable in most situations. To remedy the consequences of variable plan accounting, a hybrid vesting schedule which combines the traditional methods of step and cliff vesting with accelerated vesting for achieving certain performance goals. An example of a hybrid performance based stock option is a stock option which is set to vest at a rate of 20% per year over five years of continuous employment of the recipient; however, vesting of certain amounts of the later years options will be accelerated to a current year if the company achieves $50 million in revenues or the recipient achieves $5 million in sales during the year.

Alternatively, rather than accelerate the vesting schedule, if the performance goals are achieved during the prescribed time frame, additional stock options, which will immediately vest, could be granted to the recipient on a pre-determined basis.

(iv) Right of First Refusal

In situations where the employer wishes to remain in control of its outstanding shares and avoid gaining large numbers of shareholders, a right of first refusal can be made part of the restrictions placed upon the underlying stock. Rights of first refusal are valid on stock delivered pursuant to the exercise of both ISOs and NQSOs.

Generally, rights of first refusal restrict the sale of stock acquired pursuant to the exercise of a stock option. The restriction is fully disclosed by the company in advance to the recipient pursuant to the terms of the plan and/or the stock option grant agreement and made part of a legend placed upon each stock certificate. The right of first refusal requires that at any time the owner of the stock subjected to the right of first refusal receives or solicits an offer to purchase such stock and the shareholder wishes to sell, the shareholder must first offer the stock for sale to the employer on the same terms and conditions as the shareholder had received from the offeror. Transfers made in violation of a right of first refusal would be null and void.

(5) Right to Repurchase

Similar to the right of first refusal, many privately held companies impose a restriction which provides the company a right to repurchase from the recipient all or any portion of the stock received pursuant to the exercise of a stock option. All vested and unvested shares of stock received by a recipient pursuant to the exercise of stock options must, at the election of the company, be sold to the company following the occurrence of certain events such as (1) the termination of the recipient's service with the company for any reason, (2) the attempted transfer by the recipient of the stock in violation of the terms of the plan pursuant to which it was received and (3) the insolvency, whether voluntary or involuntary, of the recipient. Generally, the right to repurchase will expire upon the company completing a public offering.

(vi) Transfer Restrictions

Similar to the right of first refusal outlined above, transfer restrictions restrict the ways in which and the parties to which stock received from the exercise of a stock option may be transferred. Specifically, private companies try to restrict the distribution of their stock and limit the number of outstanding shareholders. This type of restriction could be used to restrict the transfer or require that transfers of shares of the employer's common stock be limited to certain types of entities or certain numbers of entities. For example, the employer may require that in the event that a shareholder who holds shares subject to such a transfer restriction wishes to sell or otherwise transfer such stock, then such sale or transfer, as the case may be, must be made to a family member of the shareholder or an entity which is not considered to be a direct competitor of the employer. Furthermore, the restriction may be all or nothing, requiring the transferring party to transfer all shares owned by such party in a single transaction or refrain from transferring any. The restriction would be fully disclosed by the company in advance to the recipient and also be expressed in a legend placed on each stock certificate. Any transfers attempted in violation of such a restriction would be null and void.

(vii) Lock-up Restrictions

For private companies, the employer can in advance subject its stock acquired pursuant to a stock option exercise to be restricted in regards to transfers during and for a specified time (usually 180 days) following the time in which the company is conducting a public offering.

(viii) Covenants Not to Compete, Confidentiality, Non-Solicitation of Customers and Employees, Etc...

As a condition of granting a stock option to a recipient, the company can require that the recipient acknowledge and agree in writing to certain covenants not to compete with the employer, not to divulge the employer's confidential information and to refrain from soliciting the employer's customers and employees. Stock options or the underlying shares granted pursuant to such covenants may become forfeited by the recipient upon a breach of these covenants. These types of covenants can be written extremely broadly, however, state courts have been reluctant to enforce covenants which unreasonably restrict the employment opportunities of the recipient.

(ix) Right of Early Exercise

Some stock options granted to directors and executive officers will provide for the ability to exercise the option prior to the underlying shares becoming vested. The ability to exercise the option without accelerating or otherwise altering the vesting criteria of the underlying stock essentially permits the director or executive officer to transform the stock option into shares of restricted stock, as more fully discussed below.

(10) Deferred Payment Alternative

An increasing number of stock option plans are providing recipients the flexibility of rather than having to pay the entire exercise price in one lump sum, being permitted to defer all or a portion of the exercise price over a prescribed time period and with prescribed terms and conditions, such as the interest rate payable.

III. RESTRICTED STOCK GRANTS

Employers that issue stock to employees, directors, independent contractors and other strategic partners sometimes impose restrictions on the stock. These types of restrictions may take many forms. Some common types of restrictions include a prohibition on the sale of the stock for a certain period of time; a right of first refusal to purchase the stock; forfeiture if the employee terminates employment before completing a specified length of service; and a requirement that the recipient sell the stock back to the company at a specified value or based upon a specified formula. During the time for which the stock is subjected to such restrictions, the recipient usually has the indicia of ownership, such as the right to vote the shares of stock and receive dividends, if any. Certificates representing shares of restricted stock are usually inscribed with a legend stating such restrictions are retained by the employer or an independent third party until such restrictions lapse.

Generally, restricted stock grants offer a greater benefit than stock options and are usually reserved for members of the company's board of directors and executive officers. Where a stock option granted with an exercise price equal to the fair market value of the underlying stock is the ideal instrument for capturing for the recipient the future appreciation in the value of such stock, restricted stock grants usually do not require the participant to put up any money to receive such stock. Accordingly, restricted stock derives its value from the actual value of the underlying stock where a stock option derives its value from the underlying stock's value in excess of the exercise price.

A. Statutory Requirements

The tax consequences of restricted stock grants are determined pursuant to Code Section 83. Basically, Code Section 83 applies to property (which includes stock of an employer) which is transferred to a service provider in exchange for such services. Pursuant to Code Section 83, stock transferred to a service provider in exchange for such services is not taxable to the service provider until such stock is substantially vested. Property becomes substantially vested when it is no longer subject to substantial risk of forfeiture. At such time, the recipient is deemed to have been vested in the restricted stock and recognizes ordinary income equal to the difference between the fair market value of the stock on the date on which it becomes substantially vested less the amount of money which the recipient is required to pay for such stock, if any. Generally, the fair market value of the stock is determined without regard to restrictions which may lapse. The recipient's tax basis in the stock is equal to the fair market value of the stock on the date it becomes substantially vested. The stock's holding period begins on the date that the stock becomes substantially vested. Any appreciation or depreciation in the value of the stock after it has become substantially vested is taxed at capital gain (or loss) rates at the time the recipient sells or disposes of the stock (assuming the stock was held as capital asset).

Additionally, the employer is entitled to a tax deduction when the recipient's right to the stock becomes substantially vested. The amount of the deduction would be equal to the ordinary income recognized by the recipient.

B. Discussion

The major advantage of restricted stock over stock options is the fact that the restricted stock has value outside of mere appreciation. Accordingly, in situations where the employer's stock value is depressed below the exercise price of outstanding stock options (ie., "underwater") restricted stock still retains some value and continues to achieve some of the employer's and recipient's goals. The major disadvantage of restricted stock is that the taxable income generated thereby is automatically generated upon the vesting of the restricted stock and basically is not controllable by the recipient. An additional disadvantage of restricted stock is that the fair market value of the stock as of the grant date must be expensed for financial accounting purposes. A NQSO, on the other hand, does not generate taxable income until the recipient actually exercises the stock option and can be designed to avoid the recognition of expense for financial accounting purposes.

C. Code Section 83(b) Election

Code Section 83(b) allows the recipient of restricted stock to make a special tax election within thirty days after receiving the restricted stock grant. The election allows the recipient to immediately take into income, at ordinary income tax rates, the difference between the fair market value of the stock, less any amount paid for such stock. As with the general rule of Code Section 83, the fair market value of the stock is determined after taking into account any non-lapsing restrictions, but without regard to any restrictions which will lapse. The election can be made only if the stock is subject to a substantial risk of forfeiture, which may include non-transferability.

If the election is made by the recipient, the recipient then recognizes ordinary income as of the date of grant instead of recognizing ordinary income as of the date that the stock becomes substantially vested. The benefit of the Code Section 83(b) election is that subsequent appreciation or depreciation is taxed as capital gain (loss) when the recipient sells or disposes of the stock (assuming the stock was held as a capital asset). The employer is entitled to a tax deduction in an amount equal to the ordinary income recognized by the recipient when the election is made and no further deduction is allowed when the recipient substantially vests in the stock or subsequently sells the stock.

The major drawback of the election is that in the event that the recipient forfeits the stock after making the election and prior to becoming substantially vested in such stock, the amount of loss is limited to the amount paid for the stock, if anything, less the amount realized upon forfeiture, if any, and no tax deduction is allowed for the amount of income recognized and taxes paid as the result of the Code Section 83(b) election. The employer must however include in its taxable income on the date of the forfeiture the lesser of the fair market value of the stock or the amount of the deduction that it took when the recipient made his or her election.

Historically, employees have not ordinarily made Code Section 83(b) elections for restricted stock, because they are required to pay income tax at the time of the election which is prior to being substantially vested in the stock. This represents cash out of pocket coupled with a risk that the recipient will have recognized ordinary income and paid the corresponding tax on property which he/she may fail to become vested in. Furthermore, the recipient may be required to obtain an appraisal of the value of the stock and he/she bears the burden of proving that his/her valuation is correct. An incorrect valuation could result in a substantial amount of additional income tax to the recipient.

Recently, due to the appreciation in the overall stock market and the valuations of "start-up high tech" firms specifically, Code Section 83(b) elections have become more common. If the recipient expects the restricted stock to substantially increase in value, then current taxation, at the stock's current low value, may represent substantial tax savings by transforming any subsequent appreciation from ordinary income rates to capital gains.

The Code Section 83(b) election is made by filing a written statement with the Internal Revenue Service (the "Service") within thirty days after the grant of the restricted stock. Such election is irrevocable without the consent of the Service and copies of such election must be filed with the recipient's tax return and the employer corporation.

D. Substantial Risk of Forfeiture

Careful drafting is required to insure that the restrictions placed upon the stock satisfy Code Section 83's requirement that the shares be subject to a substantial risk of forfeiture. The determination of whether a restriction constitutes a substantial risk of forfeiture is based on all the facts and circumstances. Generally, the instruments granting the stock must impose on the recipient a significant limitation or duty requiring a meaningful effort on the part of the recipient to fulfill. There must also be a definite possibility that the forfeiture will occur.

A non-compete agreement usually does not rise to the level of a substantial risk of forfeiture unless the recipient can prove that under the facts and circumstances that the non-compete agreement is bonafide and there is a high probability that the employer would enforce such covenants if a breach were to occur.

E. Transferability

Stock is substantially vested if it is transferable. Stock is transferable if the recipient can transfer the stock to another person whose rights in the stock are not subject to substantial risk of forfeiture. To ensure that the stock remains subject to the substantial risk of forfeiture, the restrictions should be noted in the legend of the stock certificate or shares should be held in trust by the employer or an independent trustee for the benefit of the recipient. In the case of a trust arrangement, shares held therein would systematically be released to the recipient upon vesting.

F. Performance Goal Vesting

Like stock options, the vesting of restricted stock can be subject to pre-established performance goals. The goals must be realistic and there must be some uncertainty as to whether such goals will be achieved. In such event, performance goal vesting does constitute a substantial risk of forfeiture under Code Section 83. However, there are some negative accounting ramifications for restricted stock grants based solely on performance goals.

G. Right of First Refusal

A right of first refusal gives the company the right to purchase the stock in the event that the shareholder desires to sell vested stock to a third party. Generally, the right of first refusal requires the selling shareholder after obtaining a third party offer to purchase the stock to offer such stock on the same terms and conditions to the employer. A right of first refusal does not constitute a substantial risk of forfeiture under Code Section 83.

H. Valuation

Once the stock becomes substantially vested, the employee is taxed on the difference between the fair market value of the stock and the amount paid for the stock, if any. The fair market value of the stock is determined without regard to temporary restrictions, but does take into account restrictions which will never terminate, such as a pre-determined buy back formula. The valuation of the stock can be accomplished in several different ways: (i) the Board of Directors can exercise its discretion in determining the stock's value using its business judgement; (ii) there can be a pre-determined formula; or (iii) a valuation can be conducted by an independent third party expert in conducting such valuations.

I. Repurchase Arrangements

Employers frequently require recipients of their stock to enter into repurchase arrangements as a condition of receiving stock. A repurchase arrangement usually requires the recipient to sell the stock back to the company employer or the other stockholders at a specified price upon termination of service, death, disability, retirement or other such events. Additionally, such an arrangement is an important factor in valuing the stock for income, state and gift tax purposes.

A permanent repurchase arrangement that applies to the recipient and all transferees is a restriction that will never lapse, and as such is not a substantial risk of forfeiture delaying recognition of income under Code Section 83. However, such restriction may be considered in valuing the stock. If the arrangement establishes a formula price for repurchase of the stock, the formula price ordinarily determines the taxable amount. The formula price must be reasonable and have a bonafide relationship to the fair market value. For example, formula prices include a price based on book value, a reasonable multiple of earnings, discounted cash flow or a reasonable combination thereof.

Taxpayers sometimes attempt to freeze the value of their taxable estate by entering into repurchase arrangements. This is more likely to occur in a closely held, family owned company. Intrafamily agreements are subject to special valuation rules under Code Section 2703. The special valuation rules do not apply if more than 50% of the stock subject to the right or restriction is owned by persons who are not members of the decedents family. Under the regular valuation rules, a repurchase arrangement will fix the value of the stock for estate tax purposes if (i) the tax is determinable under the terms of the arrangement, (ii) the owner of the stock is obligated to sell at the contract price, (iii) the obligation to sell at a contract price is binding on the owner of the interest during his lifetime and on his estate at death, and (iv) the arrangement is a bonafide business arrangement and not a testamentary device. Accordingly, lifetime dispositions of stock at a price other than the formula price must be restricted.

IV. PHANTOM STOCK PLANS

A phantom stock plan or "shadow stock plan" is an incentive compensation arrangement under which the recipient receives benefits measured by the value or increase in the value of the underlying employer's stock. An employee is awarded units of phantom stock under the plan. The phantom stock is not real stock, but the recipient is basically treated as if he/she were a shareholder. After a period of time specified in the plan the employee is entitled to receive deferred compensation in cash and/or stock. The phantom stock plan can base the value of the units granted on the entire valuation of the employer, the book value of the units, the fair market value of the proportional unit, a multiple of earnings per share or any other formula set out in the plan which derives an objective valuation of the units.

Some phantom stock plans provide that the recipient is entitled to receive amounts equivalent to dividends he or she would have received had the phantom stock unit been real stock. Finally, payment of the benefits under a phantom stock plan can be done in cash, stock or a combination of both. The date of payment can be a date certain or can be done on an installment basis over multiple years. Generally, a phantom stock plan is administered by making bookkeeping entries into a ledger keeping track of the number of units awarded, cash dividends, stock dividends, splits and other corporate events which will affect the value and number of units attributable to a specific recipient.

A. Taxation

Because the granting of phantom stock does not constitute the transfer of property under Code Section 83 there is no taxable event until the recipient actually takes a distribution of the benefits under the phantom stock plan.

* Upon the granting of a phantom stock award, there are no tax consequences to either the employer or the recipient.

* Upon the vesting in a phantom stock award, there are no tax consequences to either the employer or the recipient.

* Upon the distribution of cash or stock the recipient recognizes ordinary income. The amount of such income is equal to the value of cash and/or the value of any stock received for such period. The employer is entitled to a tax deduction when the employee recognizes income. The amount of such deduction is equal to the ordinary income recognized by the recipient.

B. Discussion

There are several advantages to a phantom stock plan. The plan allows the employer to provide additional compensation based on the value of its stock without diluting the stock ownership of other shareholders. Furthermore, the recipient is never entitled to vote phantom stock and the employer can decide if it would like to share dividends with the employee. The major disadvantage of a phantom stock plan is that if drafted incorrectly it could resemble a retirement plan which is covered by the Employee Retirement Income Security Act of 1974, and result in a material layer of additional regulations and requirements.

5. THE PLANNING PROCESS

The single most important element of implementing a program of stock based compensation is the planning process. The founders, directors and executives officers, as the case may be, with the assistance of the company's counsel and accountants, need to seriously consider the goals and objectives not only of the company but of the plan itself. When decision makers really sit down and consider the various stock based compensation alternatives, the perceived pros and cons of each and the myth versus reality, only then can a clear, focused and hopefully functional plan be devised. In short form, set forth below is an outline of the steps which should be undertaken to try and ensure that the stock based compensation plan implemented will accomplish the desired objectives.

1. Formulate a Plan

(i) Identify the goals of the company and the plan.

(ii) Determine who or which employment positions are key to the company's long-term success.

(iii) Determine the nature of the stock based compensation which may be the most attractive to key persons and employees which the company wishes to retain or attract.

2. Confirm the Plan

(i) Discuss the proposed plan with the company's key executives or prospective executives.

(ii) Obtain feedback on the proposed structure of the plan to determine if the company's and executive's viewpoints are substantially similar and compatible.

C. Revise the Plan

(i) Revise the plan to reflect the results of the ongoing discussions.

D. Design the Specific Measurement Criteria

(i) Develop the particular formulas or criteria to be used to measure performance, if any.

E. Implement the Plan

VI. SUMMARY

The foregoing overview is not intended to be a comprehensive discussion of stock based compensation. The intricacies of this topic could be and should be discussed at a much greater length and in greater detail. For instance, the overview does not touch upon, among other things, performance share awards or stock appreciation rights. Furthermore, many of the various points raised in this overview can be broken down into a more focused discussion. The real focus of a company's Board of Directors and executive officers should be the interrelation of these points. Simply put, designing a stock compensation plan that is right for one particular company takes a critical analysis of the objectives of the plan and a balancing of what are sometimes the competing interests of the Board and executive officers on the one hand and the employees on the other hand. If designed thoughtfully and with a thorough understanding of the complexities of stock based compensation, all parties involved should be satisfied with the outcome.

If you would like to discuss the intricacies of designing a stock based compensation program for your company, please feel free to contact us, we would be delighted to assist.