Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 10-1 Benefits of Stock Ownership Voting rights Dividend Rights Sale or Liquidation Participant Equity Growth Potential Realized at Take-Out Under Buy-Sell Capital Gains Tax Break on Gain Recognized Feel Better – Really Part of Team Treated Better – Work With Owners, not For Owners

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 10-2 Equity Structural Factors Real Cost Factor – Is anything going to be paid? Value Now Factor – Instant value or look only to future? Golden Handcuffs Factor - Can it be lost? Cash-Out Factor - The Buy-Sell agreement challenge Phantom Income Factor – A tax bill from paper stock certificate Employer’s Tax Factor – Does employer get tax break? Fall-Out Leverage Factor – If things blow, who has advantage? Real Thing Factor – Is genuine thing important?

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 10-3 Incentive Stock Options What it is? Executive given right to buy designated number of shares at designated price over designated time frame. Advantages: No income to executive at time of option grant No income to executive at time of exercise (but tax preference item to extent of excess FMV over cost) Capital gain at time of sale if not sold within two years of grant or one year of exercise

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 10-4 Incentive Stock Option Requirements Plan adopted by shareholders within 12 months of board’s adoption. Option granted within 10 years of plan adoption. Option period may not exceed 10 years. Option price not less than FMV of stock at time of grant. Option not transferable by executive, except on death. Executive can not own more than 10% of company. FMV of all stock first subject to ISOs in same calendar year (determined as of grant date) can’t exceed 100k. Executive can’t sell within 2 yrs of grant or one year of exercise to get capital gains benefits. Executive must be employee from time of grant until three months before exercise.

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 10-5 How do ISOs Stack Up Against Factors? Real Cost – You Bet! Value Now – No Way! Golden Handcuffs – can vest options over time. Cash-Out – Need agreement, may be ball game. Phantom Income – None, if no AMT. Employer’s Tax Break – None! Fall Out Leverage – Watch Out! Real Thing – That it is!

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 10-6 Nonqualified Stock Options What are they? Executive given right to buy designated number of shares at designated price over designated time frame. Tax Impacts: No income to executive at time of option grant if option not tradable and no readily ascertainable FMV of option. Yes income to executive at time of exercise – Excess of FMV of stock over option price paid. Long-term capital gain at time of sale for recognized appreciation post exercise if holding period satisfied. Yes company gets tax deduction at exercise equal to executive’s tax hit. A 409A trap if any Value Now factor – to avoid trap, must specify time to exercise (no flexibility)

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 10-7 Phantom Taxable Income Strategies Company loan: Company uses its tax savings to loan executive money to cover tax hit at exercise. Loan repaid when executive sells stock. Company Gross-Up: Company grosses up cash bonus to executive at exercise to cover tax hit on exercise and tax hit on bonus. Essentially, company shifts its tax savings from its deduction to executive. Coordinated Exercise-Sale Scenario: Plan to exercise and resell at same time. Company bonuses to give employee capital gain equivalent.

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 10-8 Nonqualified Option –Normal Scenario Nonqualified option for 10,000 $20. Executive exercises when FMV $40, pays 200k. Executive income 200k; executive tax 66k. Company gets 200k deduction at exercise, saves 68k taxes. Loans executive 66k to cover tax hit. Stock grows to $100 per share, executive sells stock to company under buy-sell for $1 mill. Executive pays off 66k loan and pays 90k (15% of 600k) capital gains taxes. Executive nets 644k after tax (1 mill less 200k cost, less 156k taxes). Net after-tax cost to company is $1 million paid to buy back stock less 68k tax savings at exercise – net 932k.

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com 10-9 Nonqualified Option – Exercise/Sale Scenario Nonqualified option for 10,000 $20. Executive delays exercise until time of sale at 1 million. At exercise, executive has 800k ordinary income – tax hit 280k. Company gets 800k deduction at exercise, saves 272k taxes. Company gross-up cash bonus to give executive capital gains equivalent of 15%. Net cost to company 160k (280k less 120k) and net benefit to executive is 160k. Executive’s net after-tax gain now 680k – 1 mill, less 200k, less 120k net tax. Company’s net cost now 888k (1 mill less 272k plus 160k)

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com Benefit Recap of Exercise/Sale Scenario Executive net after-tax gain increased from 644k to 680k. Company’s net cost reduced from 932k to 888k. Executive never comes out of pocket for 200k option price. Executive never really owns stock.

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com How do Nonqualified Options Stack Up Against Factors? Real Cost – Still there, but more flexibility. Value Now – Possible, but 409A wipes out flexibility Golden Handcuffs – Vesting requirements; Buy-Sell limits Cash-Out – Need agreement, may be ball game. Phantom Income – In spades at time of exercise. Employer’s Tax Break – Yes: deduction at exercise. Fall Out Leverage – Watch Out! Real Thing – That it is!

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com Bonus Stock What it is: Company just bonuses stock to executive. Tax Impacts: Section 83 income to executive based on FMV of stock. Section 162 deduction to company.

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com How does Bonus Stock Stack Up Against Factors? Real Cost – None. Value Now – Absolutely, but usually fewer shares. Golden Handcuffs – None. Cash-Out – Need agreement, may be ball game. Phantom Income – In spades. Employer’s Tax Break – Yes. Fall Out Leverage – Watch Out! Real Thing – That it is!

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com Restricted Stock What it is: Bonus stock with big twist – forfeiture restrictions for executive. Tax Impacts: Section 83 income to executive based on FMV of stock when forfeiture restriction lapses. Section 162 deduction to company. 83(b) election to executive – take lower tax hit at grant to get bigger capital gain break down road. No offsetting benefit if end up forfeiting stock. No 409A concerns, even with income deferral resulting from forfeiture risks.

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com How does Restricted Stock Stack Up Against Factors? Real Cost – None. Value Now – Absolutely, but usually fewer shares. Golden Handcuffs – Mucho! Cash-Out – Need agreement, may be ball game. Phantom Income – In spades. Employer’s Tax Break – Yep. Fall Out Leverage – Watch Out! Real Thing – That it is!

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com Two None Real Thing Strategies Stock Appreciation Rights: Pretend stock where executive is given upside benefit in future growth as deferred compensation. Phantom Stock or Stock Equivalency: Pretend stock with present “Value Now” and future appreciation for executive, all wrapped in deferred compensation contract. Must comply with 409A. May include gross- up bonus that provides the executive with economic equivalent capital gains benefit.

Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com How do Non-Real Things Stack Up Against Factors? Real Cost – None. Value Now – Yes, but must comply with 409A. Golden Handcuffs – If desired Cash-Out – Need agreement, may be ball game. Capital gains gross-up easy. Phantom Income – None. Employer’s Tax Break – The best, saves big. Fall Out Leverage – None! Real Thing – Never, only real negative