Stock Options

A stock option is an agreement on the part of a corporation to sell a given number of shares of its stock at a given price to an executive employee within a specified period of time. Stock options may be statutory or nonstatutory (also referred to as nonqualified), depending on whether or not they are covered in the tax code.

The determination of whether an option is statutory or nonstatutory is made as of the date the option is granted. An option is granted on the date that the company completes the corporate actions constituting an offer of stock for sale. The option cannot be granted until the maximum number of shares that an employee may purchase under the option is fixed or determinable.

Stock options must be exercised in accordance with their terms. An option is generally exercised, though, when the stock is sold to the employee or when the corporation and the employee enter into an agreement to sell the stock. The option price must be established before the option may be exercised.

Statutory stock options. There are only two surviving forms of viable statutory stock options: stock purchase plans and incentive stock options (ISOs). The rest have been essentially eliminated from the tax code.

Both types of statutory stock options essentially allow an executive to purchase company stock at a rate that is lower than fair market value. The employee is generally not subject to tax on either the grant or the exercise of a statutory stock option. When the option stock is disposed of, any gain recognized by the executive is usually subject to capital gains treatment. Alas, the corporation does not receive a corresponding business deduction.

In order to receive special tax treatment, however, the executive must not sell or dispose of stock received under an option before the required holding period for the option. Options issued under a stock purchase plan must be held for at least one year after being acquired. An ISO is subject to tax if it is disposed of within two years of the date it was granted and within one year of the date of transfer.

Did You Know? Exclusions from FICA and FUTA tax apply to remuneration from stock transfers pursuant to the exercise of an incentive stock option or under an employee stock purchase plan (or any disposition of such stock). Specifically, FICA and FUTA tax will not apply upon the exercise of a statutory stock option. Such remuneration is not taken into account for purposes of determining Social Security benefits. Additionally, federal income tax withholding is not required on a disqualifying disposition, nor when compensation is recognized in connection with an employee stock purchase plan discount.

If the holding period requirement is not met, the executive's recognition of income is still delayed until disposition of the stock, but it is taxed differently. If the stock is disposed of at a higher price than the value of the stock at the time the option is exercised, the amount between the option price and the value at the time of exercise is treated as ordinary income. The difference between the disposition price and the value at the time of exercise is taxed as capital gain. In this situation, the corporation granting the option receives a corresponding business expense deduction equal to the executive's ordinary income.

Tip Using a stock option may be a more effective way to provide retirement compensation than an annuity. Unlike a well-drafted stock option, an annuity purchased for an employee may be completely taxable to the employee in the year it is purchased.

Nonstatutory or nonqualified stock options. Unlike statutory stock options, nonqualified stock options do not qualify for favorable tax treatment under the tax code. Under a nonqualified stock option arrangement, an employee may be taxed when:

• the option is granted
• the employee exercises the option
• the employee sells or otherwise disposes of the option
• the restrictions on disposition of the option-acquired stock lapse

The tax treatment of the option also depends on whether the option has a readily ascertainable fair market value when granted to the employee. If the option has a readily ascertainable value, the employee realizes taxable income when:

• the employee's rights in the option are transferable
• the right in the option is not subject to a substantial risk of forfeiture

If the value of the option is not readily ascertainable at the time it is granted, taxation occurs when the option is exercised or otherwise disposed of. This is the case even if the fair market value may have been ascertainable before that time.

The gain realized by the employee is treated as compensation and taxed at ordinary income tax rates. The employer may take a corresponding business expense deduction at the time the employee is taxed, which is an advantage to the employer over statutory stock options.

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