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A Detailed Overview of Employee Ownership Plan Alternatives

Stock Options

ESOPs are "qualified" plans, meaning they must meet federal rules to assure that participation in them does not excessively favor more highly compensated people. Not every company wants to abide by these rules, nor does every company want the additional tax benefits they can offer. Moreover, some companies believe ownership means more if employees have to put something up to get it. Some growing companies find that contributing or purchasing existing stock is too much of a strain on either their capital structure or their finances, or both. They would prefer to give employees a right to future ownership. Many growing private companies do not pay taxes, so the tax benefits of an ESOP may not be attractive, making the greater flexibility of options more appealing. Finally, options have very favorable accounting treatment, something of particular significance to public companies.

What Is a Stock Option?

A stock option gives an employee the right to buy shares at a price fixed today (usually the market price, but sometimes lower) for a defined number of years into the future. The options might be granted on a percentage of pay basis, a merit formula, an equal basis, or any other formula the company chooses. Most broad-based plans provide grants regularly (every one to three years), either on the basis of the passage of time (every year, for instance) or an event (promotion, meeting certain corporate or group targets, or a performance appraisal, for instance). The options are typically subject to three to five-year vesting, meaning that if someone is 20% vested, he or she can only exercise 20% of the options. An employee can usually exercise vested options at any time. Most options have a ten-year life, meaning the employee can choose to buy the shares at the grant price at any time they are vested for up to 10 years. The difference between the grant price and the exercise price is called the "spread."

Most public companies offer a "cashless exercise" alternative in which the employee exercises the option, and the company gives the employee an amount of cash equal to the difference between the grant price and the exercise price, minus any taxes that are due.

Options can also be exercised with cash, although employees must have enough to pay for the shares and taxes (if any), by exchanging existing shares employee own, or by selling just enough of the shares acquired through the options to pay the costs and taxes, then keeping the remaining shares.

In closely held companies, employees usually have to wait until the company is sold or goes public to sell their shares, although some companies have arrangements to purchase the shares themselves or help facilitate buying and selling between employees. When an employee exercises an option, however, this constitutes an investment decision subject to securities laws. At a minimum, these require "anti-fraud financial disclosure statements" and, in some cases, will require securities registration as well. For this reason, broad stock options are used primarily in closely held firms when the intention is to sell or go public.

For public companies, broad options can impose a substantial dilution for other shareholders as new shares are issued to satisfy option holders. Alternatively, if the company buys shares to satisfy option exercises, there is a significant cash cost. Companies sponsoring these programs, however, contend that shareholders should be satisfied because the costs will only exist if their share price has increased. Management of these companies believes the broad options more than pay for themselves in terms of increased corporate value.

Non-Qualified Options

Most broad-based plans provide employees with non-qualified stock options, options that do not qualify for any special tax consideration. Anyone, employees or non-employees, can be given a non-qualified option on any basis the company chooses. When a non-qualified option is exercised, the employee must pay ordinary income tax on the "spread" between the grant and exercise price; the company can deduct that amount.

For example, say that Joe makes $40,000 per year. Under his company's stock option plan, he gets options worth 10% of pay each year, which vest at 20% per year over five years. So Chip gets to buy $4,000 worth of company stock at current market prices for 10 years. We'll assume that they were trading at $40 when granted, so Chip has options on 100 shares ($40 x 100 = $2,000). Assume he holds onto these options for the full 10 years. At the end of 10 years, assume the shares are now worth $100. Joe can buy 100 shares worth $100 each for just $40, making a profit of $60 per share, or $6,000, on paper. To buy the shares at $40 each, he can borrow the money or use cash. If he has existing shares, he can exchange those for the new shares he is purchasing. However he acquires the shares, he must pay ordinary income tax on $6,000 in gain. The company gets a corresponding tax deduction. Alternatively, and most commonly, he can have PepsiCo buy the shares for him, pay his tax, and give him what is left.

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 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 may be taxed under something called the 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.

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:

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. If the ISO is exercised more than three months after the employee has left the employ of the company granting the option, however, 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. However, the gains on an incentive option are subject to Alternative Minimum Tax treatment.

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 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"), or the exercise price and the sale price, if the difference is lower. If the stock price rises between the exercise and sale dates, the increase is treated as a capital gain. If shares are held after a disqualifying disposition (as could be the case if they were transferred), then any additional gain or loss would be treated as a capital gain or loss.

An employer granting an ISO is not entitled to a deduction with respect to the issuance of the option or its exercise. 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.

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