CARL WATTS & ASSOCIATES

October 13, 2014

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Employee Stock Options
Most employers have their own combination of employee benefits, or fringe benefits, that include all of the legally required employee benefits (such as worker’s compensation and social security), as well as some optional ones that they may add to the mandatory.

Optional benefits are a crucial part of business strategies, because the right mix of employee benefits will ensure that a company is able to attract, as well as retain, the right employees with desirable human capital.

Stock options are more and more frequent among fringe benefits not just for top-paid executives, but also for rank-and-file employees.

Stock options from your employer give you the right to buy a specific number of shares of your company's stock during a time and at a price that your employer specifies. Stock options as a part of the compensation package are not immediately available and will generally tie an employee for a longer period of time to the company.

The price the company sets on the stock (called the grant or strike price) is discounted and is usually the market price of the stock at the time the employee is given the options. Since those options cannot be exercised for some time, the hope is that the price of the shares will go up so that selling them later at a higher market price will yield a profit.

These stocks also have a vesting period. Most stock options vest over a three- to five-year period. Some options have vesting schedules that may allow you to redeem your options during a five-year period. This may mean that you can exercise 20 percent per year, or it may not allow you to redeem anything for three years and then 50 percent in year four and the next 50 percent in year five. These vesting schedules will all be based on how your company set up their plan.

They also have an expiration date, meaning you can exercise your options starting on a certain date and ending on a certain date. If you don't exercise the options within that period, you lose them. And if you are leaving a company, you can only exercise your vested options; you will lose any future vesting.

If you receive an option to buy stock, you may have income when you receive the option, when you exercise the option, or when you dispose of the option or stock received when you exercise the option. Of course, the IRS has something to say on all of these instances.

First of all, there are two types of stock options: statutory stock options and nonstatutory stock options.


Generally, options granted under an employee stock purchase plan or an incentive stock option (ISO) plan are considered statutory stock options.


These are also known as qualified stock options because they qualify to receive special tax treatment. No income tax is due at grant or exercise. Rather, the tax is deferred until you sell the stock.


At that point, the entire option gain (the initial spread at exercise plus any subsequent appreciation) is taxed at long-term capital gains rates, provided you sell at least two years after the option is granted and at least one year after you exercise.

Nonstatutory stock options are not granted under an employee stock purchase plan or an ISO plan.

If you are granted a statutory stock option, you generally do not include any amount in your gross income when you are granted or exercise the option.


However, you may be subject to alternative minimum tax in the year you exercise an ISO.

You have taxable income or deductible loss when you sell the stock you received by exercising the option. You generally treat this amount as a capital gain or loss.

However, if you do not meet special holding period requirements, you will have to treat income from the sale as ordinary income. These amounts, which are treated as wages, also are added to the basis of the stock in determining the gain or loss on the stock's disposition.


After exercising an ISO, you should receive from your employer a Form 3921, Exercise of an Incentive Stock Option Under Section 422(b). This form will report important dates and values needed to determine the correct amount of capital and ordinary income (if applicable) to be reported on your return.


After your first transfer or sale of stock acquired by exercising an option granted under an employee stock purchase plan, you should receive from your employer a Form 3922, Transfer of Stock Acquired Through an Employee Stock Purchase Plan under Section 423(c). This form will report important dates and values needed to determine the correct amount of capital and ordinary income to be reported on your return.


If you are granted a nonstatutory stock option, the amount of income to include and the time to include it depends on whether the fair market value of the option can be readily determined. If an option is actively traded on an established market, the fair market value of the option can be readily determined.


Most nonstatutory options do not have a readily determinable fair market value. For nonstatutory options without a readily determinable fair market value, there is no taxable event when the option is granted but the fair market value of the stock received on exercise, less the amount paid, is included in income when the option is exercised.

You have taxable income or deductible loss when you sell the stock you received by exercising the option. You generally treat this amount as a capital gain or loss.

While this newsletter is focused more on the taxation aspects of the stocks option, it is important to consider counseling from investment experts and tax professionals to make sure you take advantage of all the benefits and avoid all the risks of mishandling your option.


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