Cincinnati Tax Lawyer: Employer Stock Options


[ Home ] Employer Stock Options Stock options in one form or another have been utilized to compensate employees for many years. Stock options extend the privilege of buying a specific amount of employer stock, within a specified time, at a specified price. If a stock increases in value over the option price, the employee may exercise his option and realize the gain or he may hold the option for further possible gain. On the other hand, if there is no increase in value of the underlying stock over the option price, the employee simply does not exercise the option and thus loses nothing. The dictionary definition of a stock option is a contract giving the holder the right (not the obligation) to purchase a certain number of shares of stock in the employer corporation. There are generally two types of stock options, namely incentive stock options (ISOs) and non-qualified stock options (NQs). Both types are compensatory stock options. In the timeline of the life of an option there are three (3) main events, namely the grant, the exercise of the option, and the disposition of the underlying stock. There is no taxable event at the time of the grant. There are significant, and differing tax ramifications, at the time the employee exercises the stock option. And, there are differing tax ramifications at the time the employee sells the underlying stock. Below is a list of the general features of incentive options and non-qualified stock options. Occasionally, there is confusion as to whether an employee has ISOs or NQs. An easy rule to remember is as follows: If the economic benefit of the option is reflected in the employee's payroll stub and W-2 then that employee has exercised a non-qualified stock option. Non-Qualified Stock Options General Features NQs may be granted to either employees or to independent contractors of the employer. NQs can be granted at any strike price even below the fair market value of the stock. No required term limits - even beyond ten years. Tax consequences No income recognized at time of grant Ordinary income included in the employee's W-2 equal to the option spread on the day of the exercise of stock option. Option spread is the value of the underlying security at the time of exercise less the grant price (strike price). The option spread is deductible by the company for income tax purposes in the year the employer exercises the option. Minimum employee withholding requirement of 28% federal income taxes on taxable income (spread). Cost basis of NQ stock for future sale is equal to fair market value of the shares on date of exercise and not option cost. Disposition of underlying shares results in either long-term or short-term capital gain (can be either a gain or loss). Gain or loss equal to difference between fair market value at time of exercise and sales proceeds at time of disposition. Incentive Stock Options General Features Option price must equal the fair market value at date of grant. ISOs may be granted only to employees and not to independent contractors. Option term may not exceed ten years. Grant limited to $100,000 in stock value each year. Special rules if issued to a 10% shareholder in employer corporation. Tax Consequences No income recognized at time of grant. No income tax ramifications at time of exercise for regular income tax purposes. Employer may not deduct option spread on company tax return. ISO spread is an alternative minimum tax "preference item" to employee and often creates AMT tax liability. ISO exercise creates cash flow problems: employee must pay option price to employer and may pay alternative minimum tax to Internal Revenue Service (see discussion of alternative minimum tax elsewhere in this website) but only receives stock in return. Regular capital gains transaction at sale of underlying shares. Cost basis for regular income tax purposes is option price - and not FMV of stock on date of exercise as in the case with NQs - therefore usually subject to capital gains tax. Post - Exercise Tax Considerations Employee must hold stock for requisite holding period or there will be a disqualifying disposition and option will be treated as NQ. Employee must hold for two years from grant date or one year from exercise date to obtain benefits of long-term capital gain treatment. Careful planning required in order to utilize the benefit of alternative minimum tax credit which is created when a taxpayer is liable for AMT because of an ISO exercise. Capital gain recognized on sale of ISO stock can trigger minimum tax credit (alternative minimum tax credit) against ordinary income taxes resulting in reduced taxes in year of sale. Adjustment on sale of stock on ISO stock (difference between AMT cost basis and ordinary income tax basis) is usually negative AMT adjustment on Form 6251 in year of disposition of the ISO stock. Can create window of opportunity to exercise new ISOs without triggering current AMT and/or qualify the year for minimum tax credit against ordinary income taxes. Exercise Strategies for All Stock Options Employee may use cash to satisfy exercise cost. Employee may sell underlying stock immediately after exercising option and receiving stock. Stock proceeds available for payment of option price to employer (employer usually has this arrangement) and payment of income taxes. Employee retains remaining sales proceeds. Employee may exercise option by swapping existing employer stock to satisfy exercise cost. Cash not used to satisfy exercise price paid to employer - rather employer accepts employer stock as valued on day of swap. Stock received takes cost basis of surrendered stock. [ Home ]

Employer Stock Options

Stock options in one form or another have been utilized to compensate employees for many years. Stock options extend the privilege of buying a specific amount of employer stock, within a specified time, at a specified price. If a stock increases in value over the option price, the employee may exercise his option and realize the gain or he may hold the option for further possible gain. On the other hand, if there is no increase in value of the underlying stock over the option price, the employee simply does not exercise the option and thus loses nothing.

The dictionary definition of a stock option is a contract giving the holder the right (not the obligation) to purchase a certain number of shares of stock in the employer corporation.

There are generally two types of stock options, namely incentive stock options (ISOs) and non-qualified stock options (NQs). Both types are compensatory stock options. In the timeline of the life of an option there are three (3) main events, namely the grant, the exercise of the option, and the disposition of the underlying stock. There is no taxable event at the time of the grant. There are significant, and differing tax ramifications, at the time the employee exercises the stock option. And, there are differing tax ramifications at the time the employee sells the underlying stock. Below is a list of the general features of incentive options and non-qualified stock options. Occasionally, there is confusion as to whether an employee has ISOs or NQs. An easy rule to remember is as follows:

If the economic benefit of the option is reflected in the employee's payroll stub and W-2 then that employee has exercised a non-qualified stock option.

Non-Qualified Stock Options

General Features

NQs may be granted to either employees or to independent contractors of the employer.
NQs can be granted at any strike price even below the fair market value of the stock.
No required term limits - even beyond ten years.

Tax consequences

No income recognized at time of grant
Ordinary income included in the employee's W-2 equal to the option spread on the day of the exercise of stock option. Option spread is the value of the underlying security at the time of exercise less the grant price (strike price).
The option spread is deductible by the company for income tax purposes in the year the employer exercises the option.
Minimum employee withholding requirement of 28% federal income taxes on taxable income (spread).
Cost basis of NQ stock for future sale is equal to fair market value of the shares on date of exercise and not option cost.
Disposition of underlying shares results in either long-term or short-term capital gain (can be either a gain or loss). Gain or loss equal to difference between fair market value at time of exercise and sales proceeds at time of disposition.

Incentive Stock Options

General Features

Option price must equal the fair market value at date of grant.
ISOs may be granted only to employees and not to independent contractors.
Option term may not exceed ten years.
Grant limited to $100,000 in stock value each year.
Special rules if issued to a 10% shareholder in employer corporation.

Tax Consequences

No income recognized at time of grant.
No income tax ramifications at time of exercise for regular income tax purposes.
Employer may not deduct option spread on company tax return.
ISO spread is an alternative minimum tax "preference item" to employee and often creates AMT tax liability.
ISO exercise creates cash flow problems: employee must pay option price to employer and may pay alternative minimum tax to Internal Revenue Service (see discussion of alternative minimum tax elsewhere in this website) but only receives stock in return.
Regular capital gains transaction at sale of underlying shares. Cost basis for regular income tax purposes is option price - and not FMV of stock on date of exercise as in the case with NQs - therefore usually subject to capital gains tax.

Post - Exercise Tax Considerations

Employee must hold stock for requisite holding period or there will be a disqualifying disposition and option will be treated as NQ.
Employee must hold for two years from grant date or one year from exercise date to obtain benefits of long-term capital gain treatment.
Careful planning required in order to utilize the benefit of alternative minimum tax credit which is created when a taxpayer is liable for AMT because of an ISO exercise.
Capital gain recognized on sale of ISO stock can trigger minimum tax credit (alternative minimum tax credit) against ordinary income taxes resulting in reduced taxes in year of sale.
Adjustment on sale of stock on ISO stock (difference between AMT cost basis and ordinary income tax basis) is usually negative AMT adjustment on Form 6251 in year of disposition of the ISO stock. Can create window of opportunity to exercise new ISOs without triggering current AMT and/or qualify the year for minimum tax credit against ordinary income taxes.

Exercise Strategies for All Stock Options

Employee may use cash to satisfy exercise cost.
Employee may sell underlying stock immediately after exercising option and receiving stock. Stock proceeds available for payment of option price to employer (employer usually has this arrangement) and payment of income taxes. Employee retains remaining sales proceeds.
Employee may exercise option by swapping existing employer stock to satisfy exercise cost. Cash not used to satisfy exercise price paid to employer - rather employer accepts employer stock as valued on day of swap. Stock received takes cost basis of surrendered stock.

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