Erik Flegal
All right, everybody. Thank you for joining us for this edition of thought and action. I have David Taylor with me, my favorite nerd in the world. He’s an attorney with the Taylor Foley Law Firm, 23 years of experience. I want him to talk a little bit about his firm first, and then we’re gonna dive into incentive stock option plans, because I want to clear that up and talk about you know, the benefits of that. A little bit about the costs, and then how people you know, with a new company can really use those to let them shine. But before we get into that, David, explain, you know, a little bit about yourself and your firm so people can get to know your expertise,
David Taylor
Sure. Yeah, as you mentioned, 23 years in counting, it always amazes me to say that out loud. I was always the youngest guy in the room, and now I’m not the youngest guy in the room anymore. So we’re a transactional Tax Law Firm. And a lot of people don’t know what even a tax lawyer does or what it means. So I’ll describe it as saying we put business deals together. In any sort of business environment transaction, there are costs which are referred to as friction or burn. The most substantial usually revolves around taxation, so we mitigate the tax bite of business transactions, not only the tax bite, but our job is to make business deals more efficient, increase the yield to the parties.
Erik Flegal
Right. I was always told to be a specialist and not a generalist, and you’re definitely a specialist in what you do.
David Taylor
Right. I can promise you, there are a lot of things that I cannot do. And those I’m not a specialist in.
Erik Flegal
One of the things that you’re very adept at, that I get questions on from time to time is the, you know, the ISOP, these incentive stock option plans. And it amazes me how many different definitions people have of it. So can you just level the playing field? And let’s just start with you explaining the basics of what it is, you know, to start there
David Taylor
Sure, I’d love to. So an incentive stock option plan sounds sort of like a general description of a range of planning techniques when in reality, that’s a very specifically defined term in the Internal Revenue Code. That is narrow in its application in the broader scope of planning techniques out there, that I would characterize as key employee incentive plans, employee retention incentive plans, things that revolve around ownership interest for key people in your organization that can be conveyed and held in a tax-savvy and other otherwise savvy manner. You know, we can start talking about incentive stock option plans, and then maybe I could put that into the overall concept, or context of general incentive and employee type plans?
Erik Flegal
Sure, yeah. So let’s start with why a start-up would use an incentive stock option plan, what’s the benefit to it to an early-stage company?
David Taylor
With an incentive stock option plan, the word stock might actually give you a clue here, it’s limited to corporations. Okay. So when you are talking about an incentive stock option plan for a startup we’re talking about it in the terms of a corporately taxed entity. Right. And incentive stock option plans, by definition, are the codes are set up so that the employee or key person is granted an option to acquire the person or a key employee. They’re issued at a strike price equal to fair market value. Hence, there usually is no income tax consequences to the key person from the receipt of those options. The reason why a startup would be interested in an incentive stock option plan, most startups have a vision of growth when the value of the company greatly exceeds its strike price. So that works perfectly with a startup because most startups anticipate large growth. And it allows key persons and key executives and ownership to enjoy an income recognition event down the line and have it taxed differently. So you’re doing two things with the key person, you’re giving them a right that will hopefully grow and explode in value that they can then harvest later. And when that harvesting occurs, it is taxed at Capital Gains rates if it’s done properly and held for long enough instead of ordinary income taxed, which is a much higher rate.
Erik Flegal
So do you find that people typically set these up only in startups, or do they do this in any stage of a company?
David Taylor
Any stage of companies. I mean, it depends on the size and the posture of the company and its growth cycle, and its lifecycle. So they work very well with startups, because of the growth factor of the organization, expected growth factor. And in startups, mostly, they’re in need of leadership. So it’s good to attract quality people, it’s good to align business and interest of the key person and the owners because literally, the key person is becoming an owner. So it aligns interest, you know, promotes good taxation. So there are a lot of positive elements in a startup, that incentive stock option plans work very well with. With more mature companies, everyone probably hears about this and knows this from an executive level. It’s a great way to compensate key executives and personnel and allow them to control when their income tax recognition event occurs in house tax.
Erik Flegal
Right. So maybe this would be a good time to segue for a second and just talk about this in the context of an incentive plan in general. Just to contrast it, and then we can kind of go forward a little more on the ISOPs.
David Taylor
Sure, well, in incentive stock options, which is the defined term under the Internal Revenue Code is an even more narrow version or a subset of an already narrow silo of rules called qualified plans. And the word qualified here connotates, that there’s some sort of set of rules for these particular plans that are very objective. And if you meet those rules, you have benefits such as tax efficiencies. So instead of stock option plan is a qualified plan. And there are others, especially in the context of a corporate stock option plan, it is the particular plan. The other side of the railroad tracks if you don’t mind is the non-qualified plans. Non-qualified plans, almost by definition include non-corporate entities like partnership tax entities, LLC taxed as partnerships in the life, you know, equity funds, whatever. Non-corporate tax entities are non-qualified plans. And the neat thing about non-qualified plans in the non-corporate world is you can replicate the same sort of tax results as you get with qualified plans and even incentive stock option plans. So, you know, for your clients and viewers, anybody considering and watching us today. I would look at if you have a corporate entity, it’s in a stock option plans are one of the major players if you’re not a corporate entity, don’t give up on incentive plans, because they’re actually more flexible and greater options outside of the corporate world in the partnership tax arena. And in that, in similar reaps.
Erik Flegal
Gotcha. What type of company, you know, we talked about ideally suited to use these incentive stock option plans. Give me an idea though, of like costs, timelines typically associated to set these up. Just you know, people always say they’re expensive and hard to put together. I never quite got mine finished. You know, can you debunk that a little for me to say, Hey, this is typical cost and this is how long it takes.
David Taylor
Yeah. So typical costs, I would say, to expect it, you know, this is so relative, you know, take this for what it’s worth, which is a very general comment, but you’re probably looking at a floor a minimum of about $30,000. One misperception there is a $30,000 check that you write day one, and design and implementation of an effective plan, takes a little time. So it’s a process over some periods of months. And that cost is spread out over that period of time. I certainly have seen them done for that amount. I’ve certainly seen them done for a lot more than that. It depends on the complexity, size, and sophistication of the plan. . Timeline, I couldn’t imagine instituting an effective plan in less than two months, I would say more often it’s four to six months. It depends on the client, it depends on the need.
Erik Flegal
So who are the players that need to be involved? I know obviously, you, your firm will be drawing something up, a tax lawyer, you could say, and if they don’t necessarily use you, but then who are the other people that need to be involved so that it’s administered appropriately?
David Taylor
Again, depends on the plan. So with incentive stock plans, specifically, you don’t have as great of a need for a CPA, the internal CPA or tax advisors of the organization as you do with non-qualified plans but you still have that need. With non-qualified plans, having a good CPA or tax preparer, onboard controller CFO is essential. So you also have your key executives, they need to have good counsel. Not really legal so much as tax advisors, sometimes as a tax lawyer like us, sometimes that’s a good CPA, definitely. Your overall financial steward of your organization needs to be involved, because it is a, you know, having an in-stock option plan impacts your corporate structure, it impacts your capitalization structure, therefore, it impacts the ownership of the organization overall. Usually, for the better for the positive. But you need to have some, some guidance and some stewardship for the financial planning, of not only the current ownership, but the new owners, key executives.
Erik Flegal
Is it flexible once it’s set up, you can plug and play if you wanted to? Let’s say somebody left and you wanted to replace them? Is it flexible that way? Or is it something that once you set it up, you’re committing to something and that’s it?
David Taylor
No, it’s pretty flexible. Again, it depends on the design. That question is a great segue for me to talk a little bit about some of the things that we do that I think are unique and different. So let me give an example. This is the lawyer near to me that you mentioned earlier. My perception is that once you give legal title to an asset to an individual, that individual, rightly so as ownership rights in law, that are vested, and they belong to them. You can restrict stock ownership based on the plan and based on the key executive, employee or otherwise, but title vest in that person. And if you don’t want that title to that particular equity sliver going away forever, then you have to figure out a way to restrict it. So one of the reasons why we like non-qualified plans, in addition to qualified plans, is we’re able to have and by the way, incentive stock options can also be held this way. But we like to instead of giving title to the equity interest, the stock or the partnership, interest directly to the key executive we’ll actually have it held in a trust and irrevocable trust that the key employee and their family have all the rights and benefits of ownership, except legal title. That actually provides the key executive a lot of benefits, it’s asset protected, it’s protected for domestic relations for Family Law purposes, it’s set up for state planning to pass down generationally. There is income tax and estate tax, transfer tax efficiencies there. There are a lot of positives to the key employee, you have a vesting schedule inside of that, that trust, which is really neat. But to the company, to the owners in the leadership of the company, the equity enters never leaves the company, it is held in this trust. And often the trustee of that trust is some member of the leadership board of directors or executive staff of the organization, the actual operating company. So you have sort of a both sides benefit result. And you talked about being able to plug and play, if I have one key executive, say my CEO, leave the organization, he or she at that point, depending on whether invested or not if they have the stock at their departure, it goes with them. But a part of my plan and part of my company and its growth cycle its lifecycle doesn’t want that ownership to leave. Having held an irrevocable trust can allow us to revert the ownership interest back to the organization to be given to the to the new CEO, as a compensation piece. The actual equitable, or the actual fair market value of that interest might leave with a former executive if it’s vested. So he or she gets their money, but the ownership and the rights to control the ownership of the company stay within the company and go to the next person that’s aligned for the organization’s future.
Erik Flegal
Got it. Yeah, so those little nuances I made, I know this is gonna be a silly question. But I’m going to ask anyway. You know, people are like, why wouldn’t I just set one of these up on LegalZoom? Or try to do it on the cheap, like these little nuances make big differences over time setting it up the right way gives you that kind of that ownership flexibility, but still puts the benefit in the ballpark of, you know, the talent that you attract?
David Taylor
Yeah, I mean, to steal an analogy, there’s some things that you would do if you cut your arm, you might put a little bandaid on it or do something to close that wound. But you probably wouldn’t open up your chest and perform some sort of medical procedure that requires someone who’s well versed in what’s going on and how to make that successful. The same thing, you know, going and trying to do something this complex on your own, you know, is not going to turn out well. And you know, one of the reasons why one of your questions was why would a startup company not do this. Uncertainty, frustration of not finding the talent out there like yourself that can suggest it and put it together. So finding the right advisors around you is a big deal. But once you find those people being able to communicate the concepts clearly it’s not that complex. I want my people to be aligned with my interest, I want them to come to work every day and think like an owner, think about growth, I want them to rise with the tide as me and my family do. How they leave, that’s fine, they can take that value, but I would like to have the next person have that same alignment. Once those key concepts are communicated, putting it together as the nerd stuff, you know, conceptualizing why and how it works. It’s not that hard,
Erik Flegal
Right? People typically don’t like giving away ownership. I hear that a lot. Although I’ll say in Los Angeles, when I would see all these startups even up in San Francisco, this is like one of the first things they would do is set up one of these plans to attract the people that they want to have on, you know, onboard. What’s typical for someone who’s brand new thinking about this, what percentage ownership typically is carved off and put into these things?
David Taylor
Oh, you know, like, probably, I would say, be at 20% are starting to go into another stratosphere, I can swipe employee stock option plans, and that sort of, which are a whole different animal that’s actually geared towards bailing out your ownership to retire to the employees. 20% is kind of high, 5%, is about normal total. It depends on the number of employees. So a good average would be five to 10%.
Erik Flegal
Five to ten. And then it’s tiered as the company grows, right?
David Taylor
Depends on the plan. Yeah. I mean, depends on the industry. You know, I will say this, Erik, after these years of practicing, one thing that stood out is companies that implement this strategy tend to be the ones that take off like rockets. Companies that don’t tend to be the, you know, the mom and pop shop that might go to generation two, probably not to three, but that’s about it. So it is really, it’s been proven out to be a wonderful resource to attract talent, to retain talent, and to grow the company, because everybody’s pulling in the same direction, Situations where you might feel like you’ve given up something, but you’ve gotten so much more in return.
Erik Flegal
Right? We should’ve put that at the beginning of this. That’s the plug I’m like, how do I snip that part and put it in like, minute one? Because that’s, that’s really, I think the nugget that I wanted people to get is that I think about it, you know, five to 10% ownership with performance, you know, not without performance. And again, I know you’ve crafted all sorts of ways $30,000 to get some really talented person or group of people involved in a profitable venture. I mean, it doesn’t seem like a wild trade-off to me.
David Taylor
You spend more than that on an upfit of your office’s, multiples more than that. So investment in something that will return what that sort of planning will return is sort of a no-brainer.
Erik Flegal
Where do you find the team? I know that’s probably the next question someone’s going to ask me it’s like where do I set this up? Where do I find these talented people? Do you have any ideas?
David Taylor
Yeah, I do I mean, our clients are all over the country, as you know, really, internationally, I find, at least in our market here in Charleston, South Carolina, we are attracting more and more talent. People want to live here, but we’re attracting more and more talent because of our industry growth and the sophistication of our industries and capital structure that we’re talking about now. It’s just growing in so many higher multiples than it was over the past few years. I think at this day and age, we have the benefit of having it being a great place to live, great place to work, an organizational pool. And so I think getting those type of people to come from out of our market or those qualified people to leave the positions in our market that they’re in already, probably has everything to do with what you offer them. So if you are going to take someone from a successful company in another market or our market, one of the ways you’re going to do that is to give them ownership. How are you going to give them ownership in a tax-efficient manner that doesn’t cause them a huge tax bill upfront? Which is the worst. How are you going to make sure that they’re aligned with your interest, and then when they’re gone through death, or whatever, your business or your organization can continue on with the next level of talent.
Erik Flegal
Right. Is there anything I’m missing? I mean it seems pretty thorough to me. It’s very straightforward. And I think this, from my conversations that I’ve had smoothed out a lot of those rough edges. So anything I’m missing that you think you should want to cover?
David Taylor
No, I think I can sort of reiterate what we’ve already talked about, which is there are little, intimidating is not the right word. They’re an unknown, right? I mean, how many people would know incentive stock option is a defined term into this really fun thing to read called the Internal Revenue Code. It can be a little intimidating. But again, that’s just the technical side of things. Once you start to think about it in terms of what makes logical rational sense for my organization. Anybody probably can get behind, I’ll give away 10% or 5%, or whatever, to make my 95% worth relatively 185% 180%. Right? And how do I do that in a way that everybody loves to come to work every day, I get the talent that I want, and even when they leave, our organization is still kind of at Ground Zero. Everybody can get behind that. Right?
Erik Flegal
Good deal. This is super informative. I really appreciate your time. I really appreciate your background. It’s awesome.
David Taylor
No, no. Everybody knows I’m a big Clemson fan, so I’ve got this gamecock behind me. There’s a whole story there.
Erik Flegal
I couldn’t go the whole call without bringing it up.
David Taylor
You won’t be the only one. It’ll be mentioned to me.
Erik Flegal
Thank you again, man. I really appreciate it.
David Taylor
Thanks, Erik.
Erik Flegal
Yeah, talk to you soon.