Many companies choose to reward their employees (and in some cases even their external consultants) using warrants to purchase shares of the company (in case of issuance to employees usually called "options") instead of the traditional remuneration in the method of payment of salary. Distribution of options to employees instead of other remuneration not only allows the company to hire the services of their employees at a lower salary, but also providing an incentive for the employees to further the company's success, and no less importantly, increase the employees' incentive to remain with the company at least until all the stock options are fully vested. Nevertheless, it is important to duly construct the option mechanisms to ensure that such indeed create the incentives planned and may not cause a "tax accident" to the company or the employees.
Israeli tax laws stipulate that any benefit granted to an employee by the employer is taxed at the date of the grant as an ordinary income of the employee. The Tax Ordinance recognizes the employee stock options mechanism and enables, under certain circumstances, deferral of the tax liability to the date of exercise of the options and under certain circumstance even to the date of sale of the shares to which the options were converted. Proper construction of the stock options plan may sometime create a tax savings of up to 50% by recognizing the income as capital gains rather than ordinary labor income. The Tax Ordinance enables the company to choose between several different routes for the issuance of the stock options, each of which resulting in a different tax result, but also other implications. Thus, it is important to consult both an attorney and an accountant, each of which well familiar with this area.
For example, one may choose a route that includes depositing the options with a trustee that may defer the tax liability, under certain conditions, until the date of sale of the shares by the employee. In the capital income trustee route the trustee need hold the shares for at least two years and at the end of the day the employee will pay only a 25% tax. By contrast, selecting a labor income trustee path requires holding of the shares by the trustee for one year only. The company may choose to avoid the use of a trustee but then the employee will not enjoy the tax deferral and will be taxed upon allotment of the options (and again upon the exercise of the options and again upon the sale of the shares) or, in case of a non-tradeable option, upon the exercise of share options (and again upon sale of the share).
It is important to note that while the tax applies to the employee the employer has a withholding tax obligation and the non-withholding of the tax creates a personal liability of the company for the tax payment of the employee. Thus, it is important to ensure that the whole process is monitored by an accountant well acquainted with these issues.
A company that chooses to allocate options to any of its employees should ensure that this will be part of a comprehensive and duly structured employee stock option plan that includes all the terms of the options and the dates in which such may be exercised, all in order to prevent misunderstandings and the exposure of the company to legal and accounting risks. To this end, it is recommended that the company will be assisted by a lawyer and an account who is well familiarized with this material. By this one can ensure the use of the mechanism to commit the employees to the company's success with minimal impact on the Company's cash flow. We note also that because the mechanisms of options cannot be used by a controlling shareholder, as such term is defined in the Tax Ordinance, it is important to ensure that any investment in a start-up company is managed by an attorney specializing in mergers and acquisitions and familiarized also in this area, to prevent tax accidents to the company entrepreneurs.