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Employee Stock Options and Related Equity Incentives

By David Johanson, Johanson Berenson LLP

Broad-based employee stock ownership, when combined with an effective communications program that is designed to create an employee ownership culture, can be a very dynamic tool for improving employee productivity and thereby increasing profitability and value. Although the focus here is not solely on "broad-based" employee stock options and related equity incentives, employers should keep this basic concept in mind when designing equity incentives for any employees.

Glossary

Exercise: To elect to purchase stock pursuant to an option.
Exercise date: The date that an individual or an entity purchases stock pursuant to an option.
Exercise price: The price at which stock can be purchased pursuant to a stock option. Synonymous with "strike price."
Grant date: The date on which an option is first offered to an individual or entity.
Incentive stock option: An option, qualifying for favorable tax treatment under section 422 of the Internal Revenue Code (the "Code"), granted to an employee of a corporation to purchase company stock at a specified price for a specified period of time. Generally, there are no tax consequences until the stock is sold.
Nonqualified (nonstatutory) stock option: A stock option that does not qualify for favorable tax treatment under Code sections 422 or 423.
Qualified stock option: An option to purchase shares provided to an employee of the corporation under terms that qualify the option for special tax treatment under sections 422 or 423 of the Code. Synonymous with "statutory stock option."
Restricted stock option or restricted stock: An incentive or nonqualified stock option or stock that is subject to certain restrictions imposed by the employer; for example, employees may be required to sell their stock back to the employer upon termination of employment at the price they paid for the stock.
Section 423 stock purchase plan (sometimes called an "employee stock purchase plan" or ESPP): A plan under which a company allows employees to purchase stock at up to a 15% discount; purchasers receive favorable tax treatment if the plan meets certain rules.
Statutory stock option: A stock option (incentive stock option or section 423 stock purchase plan option) that qualifies for favorable tax treatment under sections 422 or 423 of the Code. Synonymous with "qualified stock option."
Stock option: A right issued by a corporation to an individual or an entity to buy a given amount of shares of company stock at a stated price within a specified period of time.
Strike or striking price: Price at which an option (e.g., to purchase stock) is exercised. The price at which named stock can be put or called is ordinarily the fair market value when the option is written and is termed the "striking price." Synonymous with "exercise price."

Statutory Stock Options: Overview

Two types of employee stock options receive special treatment under the Code: incentive stock options (ISOs) and options under an employee stock purchase plan (ESPP) that is qualified under Code section 423. There is no recognition of income on the option grant or on the exercise of the option under either of these programs for employee ownership, provided that certain conditions under sections 422 and 423 of the Code are satisfied, as discussed below. Additionally, if the stock is disposed of after completion of the statutory holding period, any appreciation will be taxed as capital gain.

Stock options are the most popular form of long-term compensation incentives for executives in major U.S. companies and are now being offered to most or all employees in many companies. They are very easy to administer, primarily because they do not require that the company establish any financial targets. Over 90% of the Fortune 1000 use stock options, according to a survey conducted by TPF&C, a Towers Perrin Company.

Incentive Stock Options

With an incentive stock option (ISO), a company grants the employee an option to purchase stock at some time in the future at a specified price. With an ISO, there are restrictions on how the option is to be structured and when the option stock can be transferred. The employee will exercise the option at some time when the value of the option stock is greater than the exercise price of the option. As the value of the stock increases relative to the option exercise price, the employee has the potential to benefit from the increase in the option stock's value over the option exercise price. The employee does not recognize ordinary income at option grant or exercise (although the spread between the option price and the option stock's fair market value constitutes an item of adjustment for alternative minimum tax purposes), and the company cannot deduct the related compensation expense. The employee is taxed only upon the disposition of the option stock. The gain is all capital gain for a qualifying disposition. For a disqualifying disposition (i.e., one not meeting the rules specified below for a qualifying disposition), the employee will recognize ordinary income as well as capital gain.

A disposition of ISO stock is generally defined as any sale, exchange, gift or transfer of legal title of the stock. Section 424(c) of the Code, however, provides exceptions to this general definition. The exceptions include a transfer from a decedent who held ISO stock to an estate, a transfer of ISO stock by bequest or inheritance, an exchange of ISO stock in a nonrecognition transaction such as a reorganization, a transfer of stock between spouses incident to a divorce, a transfer of ISO stock into joint ownership and a transfer of ISO stock by an insolvent individual to a trustee in bankruptcy.

Requirements for ISOs

For a stock option to qualify as an ISO (and thus receive special tax treatment under Code section 421(a)), it must meet the requirements of section 422 of the Code when granted and at all times beginning from the grant until its exercise. The requirements include:

The option may be granted only to an employee (grants to non-employee directors or independent contractors are not permitted) who must exercise the option while an employee or no later than three months after termination of employment (unless the optionee is disabled, in which case this three-month period is extended to one year). The stock option must be an option to purchase stock of the employer corporation or the stock of a parent or subsidiary corporation. The stock may be capital stock of any class of the corporation, including voting and nonvoting common or preferred stock. In addition, using special classes of stock that are authorized to be exclusively issued and held by employees is permissible.
The option must be granted under a written plan document specifying the total number of shares that may be issued and the employees who are eligible to receive the options. The plan must be approved by the stockholders within 12 months before or after plan adoption. The stockholders' approval must comply with the charter, bylaws and state laws that regulate the stockholder approval required for the issuance of corporate stock. If there is no applicable authority, the plan must be approved by a majority of all outstanding voting stock (whether such votes are in person or by proxy) at a duly held stockholders' meeting with a quorum present or by a method that would meet the applicable state law requirements for approval of actions requiring shareholder voting.
Each option must be granted under an ISO agreement, which must be written and must list the restrictions placed on exercising the ISO. Each option must set forth an offer to sell the stock at the option price and the period of time during which the option will remain open.
The option must be granted within 10 years of the earlier of adoption or shareholder approval, and the option must be exercisable only within 10 years of grant.
The option exercise price must equal or exceed the fair market value of the underlying stock at the time of grant.
The employee must not, at the time of the grant, own stock representing more than 10% of the voting power of all stock outstanding (including stock constructively owned through attribution pursuant to Code section 424(d)), unless the option exercise price is at least 110% of the fair market value and the option is not exercisable more than five years from the time of the grant.
The ISO agreement must specifically state that the ISO cannot be transferred by the option holder other than by will or by the laws of descent and that the option cannot be exercised by anyone other than the option holder.
The aggregate fair market value (determined as of the grant date) of stock bought by exercising ISOs that are exercisable for the first time cannot exceed $100,000 in a calendar year. To the extent it does, Code section 422(d) provides that such options are treated as nonqualified options.

An ISO plan may include other provisions that are not required as long as such provisions are not inconsistent with these requirements. Employers often include provisions enabling the employee to finance the exercise price. For example, the ISO plan can provide that the employee may pay for the exercise of his or her options with stock of the company. The ISO plan also may provide for tandem stock appreciation rights which will assist an employee in exercising options without cash.

The initial ISO plan document should be drafted to include any desired provisions to be used presently and also in the future so that the ISO plan does not need to be modified to include any newly desired provisions. The ISO plan also should provide for amendments.

Advantages of ISOs

ISOs enable employees to share in the appreciation and the value of the stock and provide the employer with more flexible arrangements than allowed in a qualified retirement plan. They may be designed so that employees may put their capital at risk or so that employees are given assistance in financing the exercise price through the use of stock and option exercise programs and employee loan programs. Employees can realize the compensatory gains on the options while employed rather than having to wait until termination of employment. Options also provide executives with the opportunity to realize almost unlimited gains. In addition, the employer can tailor ISOs to benefit particular employees, which would not be possible in a qualified retirement plan.

From the employer's standpoint, the most important advantage of ISOs is that they enable a company to attract and keep talent without draining cash flow by paying higher salaries. ISOs should be especially helpful for cash-poor companies with good growth prospects. This is not as true anymore, however, as high-tech employees begin to expect high current compensation and substantial growth potential from options.

From the employee's standpoint, an employee receiving an ISO recognizes no taxable income upon the ISO's receipt or exercise. If the ISO is exercised more than three months after the employee has left the employ of the company granting the option, however, this favorable tax treatment is not available.

Upon a qualifying disposition, the employee recognizes capital gain, measured by the difference between the option exercise price and the sale proceeds. After the Tax Reform Act of 1986, which substantially reduced the progressive nature of the individual taxpayer's rate structure and repealed favorable tax rates for capital gains, the tax advantage realized upon disposition of the stock was reduced. As of this writing, there is a substantial differential between the top marginal rate for ordinary income and the capital gains tax rate for most taxpayers. However, ISOs generally are not useful for broad-based stock option plans because most nonmanagerial employees will have ordinary income and capital gains rates that are very close. In any event, most employees in broad-based stock option plans do not hold onto their stock after exercise long enough to qualify for capital gains treatment.

Tax Implications of ISOs for Employees

An employee receiving an ISO realizes no income upon its receipt or exercise. Instead, the employee is taxed upon disposition of the stock acquired pursuant to the ISO. A disposition of ISO stock generally refers to any sale, exchange, gift or transfer of legal title of stock. The tax treatment of the disposition of option exercise stock depends upon whether the stock was disposed of in a qualifying disposition within the statutory holding period for ISO stock. The ISO statutory holding period is the later of two years from the date of the granting of the ISO to the employee or one year from the date that the shares were transferred to the employee upon exercise.

Disqualifying Disposition If disposition occurs within two years of the employee's receipt of the option or within one year of receipt of the stock, the employee recognizes at the time of the disposition (1) ordinary income measured by the difference between the option exercise price and the fair market value of the stock at the time of option exercise (the "bargain purchase element"), and (2) capital gain measured by the difference between the fair market value of the stock on the date of exercise and the disposition proceeds.

EXAMPLE: On January 1, 1992, X, an employee of ABC Corp., is granted 100 ISOs to purchase shares of ABC Corp. stock at $10 per share, the fair market value of ABC stock at the time of the grant. On March 20, 1993, X exercises all of her ISOs when the price of ABC Corp. stock is $15 per share. On December 31, 1993, X disposes of (sells) 50 shares of ABC Corp. stock acquired pursuant to the ISO before the end of the ISO statutory holding period for $17 per share. X must recognize, in 1993, $250 in ordinary income (50 shares multiplied by the bargain purchase element at exercise of $5). In addition, the capital gains portion of the disqualifying disposition is $100 (50 shares multiplied by the difference between the $17 per share sales price and the basis of the ISO stock of $15, which is the sum of the exercise price for each share, $10, plus the additional compensation amount recognized in this year, $5).

Qualifying Disposition When an employee disposes of ISO stock after completion of the holding period (the later of two years after the employee's receipt of the option or one year after the employee's receipt of the stock), then all of the gain is capital gain, measured by the difference between the option exercise price and the sale proceeds.

Alternative Minimum Tax Considerations Although the exercise of an ISO does not result in an immediate taxable event, there are implications for calculating the Alternative Minimum Tax (AMT). The spread between the option exercise price and the fair market value of the option stock at exercise is treated as an "item of adjustment" for AMT purposes. If a disqualifying disposition occurs in the year in which the option is exercised, however, the maximum amount that will be included as AMT income is the gain on the disposition of the ISO stock. For a disqualifying disposition in the year other than the year of exercise, the income on the disqualifying disposition will not be considered income for AMT purposes. If an employee's items of adjustment for ISOs and for other AMT purposes is substantial (when reviewed alone or together with other items of adjustment), such employee should consult with a tax advisor prior to exercising an ISO and/or selling option stock.

Tax Implications for Employers

An employer granting an ISO is not entitled to a deduction with respect to the issuance of the option or its exercise. The amount received by the employer as the exercise price will be considered the amount received by the employer for the transfer of the ISO stock. If the employee causes the option to be disqualified (by disposing of his or her stock prematurely prior to the end of the requisite holding period), however, the employer usually may take a deduction for that amount recognized by the employee as ordinary income in the same year as the employee recognizes the income.

In addition, the employer that granted the ISO does not have any withholding obligation with regard to the ordinary income an employee recognizes upon a disqualifying disposition (the Internal Revenue Service [IRS] may change this position). The ordinary income resulting from the disqualifying disposition also is not considered wages for FICA or FUTA purposes.

An ISO generally is not subject to ERISA. Therefore, it is not subject to ERISA's reporting requirements. The employer must furnish a statement to the employee who exercises an ISO, however, on or before January 31 of the year following the year of the ISO exercise stating details about the options granted.

Section 423 Employee Stock Purchase Plans

The second type of employee stock options that receive special treatment under the Code are options granted under an ESPP ("purchase plan option"), also referred to as "section 423 plans." Section 423 of the Code provides a basis for employee stock purchase plans to receive favorable tax treatment under section 421(a) (i.e., no tax consequences on grant and capital gains treatment upon a qualifying disposition). Like ISOs, the purchase plan option gives employees an opportunity to share in the growth potential of the company's stock. Purchase plan options are used by employers as a method for employees to purchase stock, usually using payroll deductions to pay for the shares. What the option exercise price is and when the option is granted are variables. Purchase plan options are primarily intended for rank-and-file employees (unlike ISOs, which are primarily intended for key employees).

Requirements for Employee Stock Purchase Plans

Employees receive Code section 421(a)'s favorable tax treatment only if the employee stock purchase plan meets these requirements:

Only employees of the employer sponsoring the ESPP and employees of parent or subsidiary companies may participate in the ESSP.
To receive favorable tax treatment, an employee can own no more than 5% of the voting power of the employer or 5% of the value of all shares of stock of the employer.
The ESPP must be approved by the shareholders of the granting company within 12 months before or after the ESPP is adopted.
The stock for which the ESPP offers options must be the capital stock of the employer. This capital stock can be of any class, including voting or nonvoting common or preferred stock. It may be treasury stock or stock of original issue. A special class of stock authorized and issued solely to employees also would qualify as stock for this purpose.
All employees of the sponsoring employer must be included in the ESPP. Employees who have been employed for less than two years, employees whose customary employment is 20 hours or less per week, employees whose customary employment is for not more than five months in any calendar year, and highly compensated employees as defined in Code section 414(q), however, can be excluded from participation in the ESPP. These eligibility rules are similar (but not the same) as those for qualified retirement plans.
The determination of the option exercise price, the option payment provisions, and all other provisions must be uniform for all employees, with the following exceptions:

The ESPP may limit the maximum amount of options that can be exercised under the ESPP.
The ESPP may limit the amount of options that all employees may be granted to a specified relationship to total compensation or the base or regular rate of compensation.

The ESPP must provide that no employee can accrue the right at any time to purchase stock of his or her employer at a rate that exceeds $25,000 of the fair market value of such stock (determined when the option is granted) for each calendar year for which the option was outstanding. The regulations allow an employee to buy more than $25,000 of stock in a calendar year, so long as the total amount of stock which he or she buys does not exceed $25,000 in fair market value (determined at date of grant) for each calendar year in which the option was outstanding.
The exercise price of the options granted under an ESPP must be no less than 85% of the stock's fair market value at the time the option is granted, or an amount which under the option's terms cannot be less than 85% of the stock's fair market value at the time the option is exercised.For example, if an employee is granted an option at $85 for stock worth $105 at that time, the option does not qualify even if the stock falls to $100 or less when exercised.
The maximum allowable option exercise period is five years from the date of the option grant for an option that contains an exercise price at least 85% of the fair market value of the company's stock. If the option exercise price is determined in any other manner, such as a fixed dollar amount that will not be less than 85% of the fair market value of such stock at the time of the exercise of the option, the option must be exercised within 27 months from the date of the grant of the option.
The options granted in the ESPP must not be transferable other than by will or by the laws of descent and distribution. Only the employee may exercise the option during his or her lifetime.

If the terms of an offering under a purchase plan option do not meet the above requirements, all options granted under that offering will be treated as not having been granted under a section 423 plan. A purchase plan option, like an ISO plan, can contain additional terms as long as such terms do not contravene any of the requirements for a purchase plan option. Additional terms could include when an option will be granted, the method of payment of the option exercise price and limitations on when options can be exercised. Restrictions also can be placed on the underlying option stock.

Advantages

Many of the benefits derived from section 423 purchase plan options are similar to benefits derived from ISOs. Under both types of plans, there is no tax on either the grant or the exercise of an option. The employee is not taxed until he or she sells the underlying stock. The income recognized at that time generally is recognized as a capital gain. In addition, the employer is able to implement work incentives for its employees without draining valuable liquid assets.

The requirements under the Code for ESPPs are, generally, more liberal than those governing ISOs. A key feature of a purchase plan option (that differs from an ISO) is that it can offer options with an option price of between 85% and 100% of the fair market value of the stock, either at grant or exercise. ISOs must be offered at an option price of the fair market value of the stock. Employees will not recognize ordinary income when an option is exercised but will recognize such income at a later disposition of the stock if the ESPP meets the requirements of a purchase plan option.

Tax Implications for Employees

Neither the grant of an option under a purchase plan option nor the exercise of an option granted under an ESPP has any tax consequences to employees, provided the option is granted pursuant to a Code section 423 purchase plan. Employees are not taxed until they sell the stock acquired through exercise of the option. Employees generally treat any proceeds received from such a sale as capital gain. There are two situations, however, where employees may be subjected to ordinary income tax. The first situation occurs if the option exercise price is below the full fair market value of stock at the time the option is granted. The second is a "disqualifying" disposition of the stock.

Below Fair Market Value The first situation occurs if the option exercise price is below the full fair market value of the stock when the option is granted. In this situation, the employee must include as ordinary income at the time of sale of the option stock or upon the employee's death while still holding the option stock (the transfer of option stock to the estate or beneficiary of a deceased employee is treated as a disposition of the stock for purposes of this rule) the lesser of: (1) the amount, if any, by which the fair market value of the stock when the option was granted exceeds the option exercise price; or (2) the amount, if any, by which the stock's fair market value at the time of such disposition or death exceeds the exercise price paid. This applies regardless of whether the employee has held the stock for the statutory holding period.

EXAMPLE: On January 1, 1992, all employees at X Corp. are granted options to purchase X Corp. stock at 85% of the stock's fair market value (currently $100). A holds 10 options for five years. In 1997, A dies when the fair market value of X Corp. stock is $95 per share. A's estate will recognize $100 of ordinary income in the year of A's death. This amount is the lesser of $150 (the difference between the $100 fair market value on the date of grant and the $85 exercise price on the date of grant, multiplied by 10 options) or $100 (the difference between the option exercise price of $85 and the fair market value of the option stock at the time of disposition, $95, multiplied by 10).

Disqualifying Disposition As with an ISO, any disposition of stock before the expiration of the statutory holding period, the later of two years after the granting of an option or one year from the date of transfer of stock pursuant to the option, is a disqualifying disposition. For any disqualifying disposition, the employee recognizes at the time of disposition first, ordinary income measured by the difference between the option's exercise price and the fair market value of the stock at the time of option exercise (the "bargain purchase element"), and second, capital gain measured by the difference between the fair market value of the stock on the date of exercise and the disposition proceeds.

Qualifying Disposition If the disposition of stock occurs after the statutory holding period has expired, the employee will have capital gain measured by the sale proceeds less the employee's basis in the option stock. The basis in the stock would equal the option exercise price plus any ordinary income recognized due to a below-fair market value option.

EXAMPLE: On January 1, 1990, all employees of X Corp. are granted options to purchase X Corp. stock at 85% of the stock's fair market value. A exercises 10 options at date of grant when X Corp. stock has a fair market value of $100 per share. A holds the X Corp. stock for five years and sells all her shares for $200 per share. In 1995, A will recognize $150 in compensation income (the difference between the $100 fair market value on the date of exercise and the $85 exercise price on the date of grant multiplied by 10 options). The amount of capital gains on the disposition (sale) of stock is $1,000 (the $200 purchase price minus the adjusted basis of the stock-i.e., the original basis of $85 plus the $15 in ordinary income-multiplied by 10 shares).

Tax Implications for Employers

Generally, the granting employer may not take a tax deduction. The employer may take a deduction for any disqualifying disposition. The compensation deduction will be equal to the amount that the employee includes as ordinary income, and the employer will take the deduction in the year of the disposition. The employer may not deduct the difference between the fair market value of the option stock and the option exercise price.

The employer may be required to withhold income tax on a disqualifying disposition from a purchase plan option. In addition, FICA and FUTA tax also is imposed upon a disqualifying disposition. These rules also differ from those for ISOs.

A purchase plan option generally is not subject to ERISA. Therefore, it is not subject to ERISA's reporting requirements.

Nonqualified (Nonstatutory) Stock Options

The term "nonqualified stock option" or "nonstatutory stock option" refers to a number of types of options to purchase company stock that, for some reason, does not satisfy the legal requirements to qualify as an ISO or a purchase plan option. Many broad-based plans (other than section 423 purchase plans) are nonqualified. A nonqualified option is the simplest of the three types of stock options (incentive stock options, section 423 plans and nonqualified stock options). A nonqualified option plan allows employees to purchase shares at a fixed exercise price for a specified number of years into the future, often subject to vesting rules.

A nonqualified stock option is generally taxed to the employee at grant only if it (the option) has a readily ascertainable fair market value at that time, which nonqualified stock options almost never do. If it does not have such a value at grant, it is generally taxed at the time of exercise. The employer has a corresponding compensation deduction at the time of exercise.

Most nonqualified stock options are structured such that employees receive the right to purchase a certain number of shares of stock at a predetermined price. That option may be exercisable immediately or after the passage of a certain amount of time or upon the occurrence of a certain event.

EXAMPLE: On July 1, 1995, Corporation S grants to A, in consideration for services rendered, options to purchase 1,000 shares of S common stock. The option price is $10 per share, the stock's fair market value at the date of grant. On July 1, 1999, when the stock's value is $40 per share, A exercises the options in full, acquiring 1,000 shares for $10 per share. On July 1, 2000, when the stock's value is $50 per share, A sells the 1,000 shares. Because the option did not have an ascertainable fair market value at the date of grant, there is no taxable event as a result of the grant. In 1999, when A exercises the option, he recognizes $30 per share compensation income. Under Code section 83(a), the difference between the fair market value of the stock received pursuant to the option exercise ($40 per share) and the amount paid for the stock ($10 per share) is compensation income.

Advantages

Most employers using nonqualified stock options are trying to attain the same (or similar) benefits as are provided by a statutory option without the necessity of conforming to the same requirements of the Code. Using nonqualified stock options to compensate and provide an incentive for employees, the employer is able to give them a tangible reward for their efforts without using any liquid cash resources. As a result of the option, employees receive an opportunity to share in the future growth of the company.

Tax Implications Generally

The tax implications of a nonqualified stock option are governed by section 83 of the Code. Generally, Code section 83 will apply to the grant of the nonqualified option if the option itself, upon grant, has a readily ascertainable fair market value. An option to acquire nonpublicly traded stock does not have a readily ascertainable fair market value. Section 83 of the Code will apply to the exercise of a nonpublicly traded nonqualified option if the property subject to the option does not, at the time of grant, have a readily ascertainable fair market value.

As a generalization, unless a nonqualified stock option has a fair market value that can be readily determined, it will not result in a taxable transaction upon the employee's receipt of the option.

Readily Ascertainable Fair Market Value

Generally, Code section 83(a) imposes ordinary income taxes on an employee upon the receipt of compensatory property at its fair market value. When property is received in the form of a nonqualified stock option, however, Code section 83(e)(3) requires that the option must have a readily ascertainable fair market value. If an option granted to an employee is actively traded on an established market, the option value has a readily ascertainable fair market value. Such an option would be taxable at its grant under Code section 83(a). Note that the option itself must be tradable, not the underlying stock. Few employee options are traded on stock exchanges.

Options that are not actively traded on an established market do not have a readily ascertainable fair market value unless the fair market value "can otherwise be measured with reasonable accuracy." The regulations create an irrebuttable presumption that an untraded option does not have a readily ascertainable fair market value unless four conditions are met, including the following:

The option is transferable by the optionee.
The option is exercisable immediately in full by the optionee.
Neither the option nor the underlying property is subject to any restrictions that have a significant effect on the option's value.
The purchase fair market value of the option privilege is readily ascertainable. Therefore, almost all options for stock not actively traded will be deemed not to have a readily ascertainable fair market value.

Tax Implications for Employees

Publicly Traded Options A publicly traded option having a readily ascertainable fair market value will be taxed at grant. The employee will recognize ordinary income in the amount of the fair market value of the option less any amount paid for the option. Once the option's grant is taxed, the transaction's ordinary income consequences to the employee are closed. Thus, once the employee exercises the option, there will be no further ordinary income tax consequences.

If the stock is held as a capital asset, the employee will receive long-term capital gain treatment for the gain recognized upon its disposition. The amount of the capital gain will be measured by the difference between the selling price less any amount paid for the exercise of the option and any amount included in income upon the option's grant.

Options Not Publicly Traded If, as is almost always the case, the option is a nonqualified stock option without a readily ascertainable fair market value at date of grant, there is no taxable event as a result of the grant. The compensatory aspects of the option remain open until the option is exercised. Once the employee exercises the option, he or she will recognize ordinary income equal to the amount of the fair market value of the stock when it is exercised minus any amount paid for the option. The effect of not having a taxable event at the time of the grant is to treat the appreciation in the value of the property as ordinary income and not as capital gain. However, if the stock is held after exercise, any additional gain is then generally treated as capital gain.

Tax Implications for Employers

The employer has a corresponding deduction (in the same amount and at the same time) as the ordinary income recognized by the employee. In general, compensation paid in the form of stock options normally triggers the receipt of wages for the purpose of employment tax and withholding provisions in the amount of the income generated under Code section 83(a).

Choosing Between Statutory and Nonstatutory (Nonqualified) Stock Options

An employer has the choice of two types of stock options that can be used to compensate employees: statutory (i.e., incentive or section 423) options or nonstatutory (i.e., nonqualified) options. Any statutory stock option plan also may provide for the granting of nonstatutory options, as long as the plan does not provide for tandem options. (In the case of tandem options, two options are issued together and the exercise of one affects the exercise of the other. This is not permitted because it may evade the section 422A qualification requirements.) The differences between statutory and nonstatutory options are as follows:

If in the year in which gain is recognized there is little or no difference between ordinary income and capital gain marginal tax rates, one of the principal advantages (taxation at a capital gains rate) of the statutory stock option is removed.
The company obtains a deduction on exercise of a nonstatutory option equal to the income recognized by the employee. The company generally receives no deduction in the statutory stock option context unless there is a premature disposition by the employee.
The statutory option is still arguably preferable for the key employee because no income is recognized on the exercise of the option (unlike the situation with the typical nonstatutory option); income recognition of a statutory option is deferred until the employee disposes of the stock.
Nonstatutory options provide the employer with flexibility in plan design (because of lack of qualification rules). As a result, employers can tailor nonstatutory options to meet their particular needs. For example, nonstatutory options may be granted to non-employees, such as valued outside contractors or non-employee directors.
There is no requirement that the option price of a nonstatutory option be equal to the fair market value of the stock at the time of the option grant. Thus, the grantor of the nonstatutory option has complete freedom in setting the option price and the bargain purchase element.
Unlike statutory options, nonstatutory options can be granted pursuant to a plan that is effective for longer than 10 years, and the options can be outstanding for periods over 10 years from date of grant.
Nonstatutory options may be fully transferable, and there need not be any restrictions on the amount of options that can be exercised in a single year nor when the employee can dispose of the option stock after exercise.

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