One strategy companies have used in recent years is to
reward employees with options to purchase a certain amount
of the company's stock for a fixed price after a defined
period of time. The employee is not required to exercise
the option. Usually (and hopefully), by the time the
employee's options vest (become eligible for exercising),
the market price of the stock has gone up, and they get to
buy the stock for a lower price than what it's going for in
the current market.
A stock option is a contract which allows the holder to
purchase stock at a fixed price, typically known as the
"exercise price".
There are two classifications of employee stock options:
(1) statutory or qualified options (i.e. the tax treatment
of the options is governed by specific Internal Revenue
Code Sections) and (2) Nonqualified stock options (i.e.,
stock options that do not meet specific requirements in the
Internal Revenue Code for special tax treatment).
There are two types of qualified stock options: Incentive
stock options (ISO) and options written under the employee
stock purchase plans (ESPP)
- Tax Implications of Exercising Qualified Stock Options -
Generally, an ISO allows the grantee to postpone taxation
of option gains until option shares are disposed of, at
which time the gain will be taxed at favorable capital
gains rates.
- Employee Stock Purchase Plans (ESPP) -
Employee stock purchase plans are written,
shareholder-approved plans under which employees are
granted options to purchase shares of their employer's
stock or the stock of a parent or subsidiary corporation
for not less than 85% of their fair market value.
If the option price is less than the fair market value of
the stock at the time the option is granted, the employee
recognizes ordinary income in the amount of the lesser of
(1) difference between the fair market value of the shares
when sold (or the fair market value of the shares at the
employee's death while owning the shares) and the option
price for the shares or (2) the difference between the
option price and the fair market value of the shares when
the option was granted. The balance of the gain is treated
as capital gain.
- Tax Implications of Exercising Nonqualified Stock Options
-
Typically, income is recognized at the time an employee
exercises nonqualified options. The amount included as
taxable compensation is the fair market value (FMV) of the
stock on the exercise date, minus the amount paid (exercise
price). Compensation is reported to an employee in box 1
of form W-2 and in box 12 with a code "v." Income and
employment taxes are withheld on this income. For our
purposes, let's assume that you receive options for stock
that is actively traded on an established market such as
NASDAQ, but that the options themselves aren't traded. With
this type of option you must recognize taxable income equal
to what's called the compensation element when you exercise
the stock options and purchase the stock.
- Compensation Element Defined -
Your compensation element is basically the amount of
discount that you get when you buy the stock using your
options. It's calculated as (market value - stock grant
price) x number of shares you buy
The market value of the stock is the stock value on the
date you exercise the options (i.e., the date you buy the
stock under your option agreement).
The stock grant price is the amount that you can buy the
stock for per your option agreement.
Your employer is required to report the compensation
element on your Form W-2 for the year you exercise the
options.
- Restricted Stock Awards -
Unlike options, which may or may not be exercised,
restricted stock awards put shares into the grantee's name
up front, subject to forfeiture during the period of
restriction. Any price paid by the grantee is typically
well below market (if the shares are newly issued, state
corporation law may require a payment equal to par value),
and when the restrictions lapse the grantee will have
gained something even if the market price has fallen. The
nature and duration of the conditions attached to
restricted stock can be specifically tailored for each
grantee. In many cases, the condition is simply continued
employment for a specified period.
- Tax Treatment of Restricted Stock Awards -
The excess of the restricted stock's market value at the
date when the risk of forfeiture or restrictions on
transferability lapse over any price paid for the stock is
treated as compensation income to the grantee, and any
subsequent change in the value of the shares will be
recognized for tax purposes as capital gain or loss upon
disposition of the shares.
- Section 83(b) Elections -
In the alternative, the grantee may elect under I.R.C.
§ 83(b) to recognize compensation income at the time
of the initial transfer of the shares, based on the value
of the shares at that time (rather than at the time of
vesting). No income will be recognized upon lapse of the
risk of forfeiture or restrictions on transferability and
subsequent appreciation or depreciation will be recognized
as capital gain or loss. The grantee will not be entitled
to any loss deduction if the shares with respect to which a
§ 83(b) election was made are later forfeited.
- Conclusion -
Stock options can be a great way for employers to increase
the compensation package of their employees and a great way
for employees to invest in their employer. Just remember
that there are numerous tax effects that vary based on the
type of option. Be sure to check with your Tax Coach
whenever you receive the opportunity to acquire an option
in your company.
----------------------------------------------------
Tom Wheelwright is not only the founder and CEO of
Provision, but he is the creative force behind Provision
Wealth Strategists. In addition to his management
responsibilities, Tom likes to coach clients on wealth,
business, and tax strategies. Along with his frequent
seminars on these strategies, Tom is an adjunct professor
in the Masters of Tax program at Arizona State University.
For more information please visit
http://www.provisionwealth.com
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