No Soup For You!

“No soup for you!”

The reference of course is to the soup Nazi in the Seinfield television series. His name is Al Yegeneh. You can still buy his soup should you find yourself in New York or New Jersey.

However, it is not Al who we are interested in.

We instead are interested in Robert Bertrand, the CEO of Soupman, Inc, a company that licenses Al’s likeness and recipes. Think franchise and you are on the right track.

Bertrand however has drawn the ire of the IRS. He has been charged with disbursing approximately $3 million of unreported payroll, in the form of cash and stock.

The IRS says that $3 million of payroll is about $600,000 of unpaid federal payroll taxes.    

Payroll taxes – as we have discussed before – have some of the nastiest penalties going.

And that is just for paying the taxes late.

Do not pay the taxes – as Bertrand is charged – and the problem only escalates. He faces up to five years in prison. His daughter co-signed a $50,000 bond so he could get out of jail.

BTW the judge also ordered him to hire an attorney.

COMMENT: I don’t get it either. One of the first things I would have done was to hire a tax attorney.

I have not been able to discover which flavor of stock-as-compensation Soupman, Inc used, although I have a guess.

My guess is that Soupman Inc used nonqualified stock options.

COMMENT: There are multiple ways to incorporate stock into a compensation package. Nonqualified options (“nonquals” or “NSO’s”) are one, but qualified stock options (“ISO’s”) or restricted stock awards (“RSA’s”) are also available. Today we are talking only about nonquals.

Using nonquals, Soupman Inc would not grant stock immediately. The options would have a delay – such as requiring one to work there for a certain number of years before being able to exercise the option. Then there is the matter of price: will the option exercise for stock value at the time (not much of an incentive, if you ask me) or at some reduced price (zero, for example, would be a great incentive).

Let’s use some numbers to understand how nonquals work.

• Let’s start with a great key employee that we are very interested in retaining. We will call him Steve.
• Let’s grant Steve nonqualified options for 50,000 shares. Steve can buy stock at $10/share. As the stock is presently selling at $20/share, this is a good deal for Steve.
• But Steve cannot buy the stock right now. No, no, he has to wait at least 4 years, then he has six years after that to exercise. He can exercise once a year, after which he has to wait until next year. He can exercise as much of the stock as he likes, up to the 50,000-share maximum.
• There is a serious tax trap in here that we need to avoid, and it has to do with Steve having unfettered discretion over the option. For example, we cannot allow Steve to borrow against the option or allow him to sell the option to another person. The IRS could then argue that Steve is so close to actually having cash that he is taxable – right now. That would be bad.

Let’s fast forward six years and Steve exercises the option in full. The stock is worth $110 per share.

Steve has federal income tax withholding.

Steve has FICA withholding.

Steve has state tax withholding.

Where is the cash coming from for all this withholding?

The easiest solution is if Steve is still getting a regular paycheck. The employer would dip into that paycheck to take out all the withholdings on the option exercise.

OBSERVATION: Another way would be for Steve to sell enough stock to cover his withholdings. The nerd term for this is “cashless.”

It may be that the withholdings are so large they would swamp Steve’s regular paycheck. Maybe Steve writes a check to cover the withholdings.

COMMENT: If I know Steve, he is retiring when the checks clear.

Steve has income. It will show up on his W-2. He will include that option exercise (via his W-2) on his tax return for the year. The government got its vig.

How about the employer?

Steve’s employer has a tax deduction equal to the income included on Steve’s W-2.

The employer also has employer payroll taxes, such as:

·      Employer FICA

·      Federal unemployment

·      State unemployment

Let’s be honest, the employer payroll taxes are a drop in the bucket compared to Steve’s income from exercising the option.

Why would Steve’s employer do this?

There are two reasons. One is obvious; the second perhaps not as much.

One reason is that the employer wants to hold onto Steve. The stock option serves as a handcuff. There is enough there to entice Steve to stay, at least for a few years.

The second is that the employer manufactured a tax deduction almost out of thin air.

Huh?

How many shares did Steve exercise?

50,000.

What was the bargain element in the option exercise?

$110 - $10 = $100. Times 50,000 shares is $5,000,000 to Steve.

How much cash did the employer part with to pay Steve?

Whatever the employer FICA, federal and state unemployment taxes are – undoubtedly a lot less than $5,000,000.

Tax loophole! How Congress allow this? Unfair! Canadian football!

I disagree.

Why?

To my way of thinking, Steve is paying taxes on $5,000,000, so it is only fair that his employer gets to deduct the same $5,000,000. To argue otherwise is to wander into the-sound-of-one-hand-clapping territory.    

But, but … the employer did not actually pay $5,000,000.
   

COMMENT: Sometimes the numbers go exponential. Mark Zuckerberg, for example, had options to purchase 120 million shares for just 6 cents per share when Facebook went public at $38 per share. The “but, but …” crowd would want to see a $4,550,000,000 check.

I admit: so would I. I would frame the check. After I cashed it. It would also be my Christmas card every year.

You are starting to understand why Silicon Valley start-up companies like nonqualified stock options. Their cost right now is nada, but it can be a very nice tax deduction down the road when the company hits it big.

I suspect that Soupman, Inc did something like the above.

They just forgot to send in Steve’s withholdings.