PRIMER ON STOCK OPTIONS AND STOCK OPTION PLANS

Introduction

Incentive Stock Options

• Beneficial Tax Treatment for ISO Holders
• Tax Effect on Corporation
• Alternative Minimum Tax Considerations
• Requirements for Treatment as ISO

Non-Statutory Stock Options

• Definition and Typical Provisions
• Tax Consequences of NSOs
• Alternative Minimum Tax

Conclusion

1. Introduction

Stock options can be divided into two types: incentive stock options, which receive special tax treatment, and non-statutory (also called non-qualified) stock options, which have no special tax treatment (the two types will be referred to here as “ISOs” and “NSOs”, respectively).

Because many provisions regarding option grants are prescribed by statute, we often refer to specific sections of U.S. Internal Revenue Code in this letter. All references to the “Code” refer to the Internal Revenue Code.

The purpose of this summary is to provide an overview of some of the important provisions regarding options and some of the tax consequences of exercising options. You should note that this document should not serve as a substitute for the personal tax advice you or your employees may or will need. Furthermore, this letter only covers major issues and does not address all the tax rules, and an individual’s tax situation may differ greatly from the norm. Nor does this letter address state or foreign tax consequences, which also may be significant. Finally, this summary assumes optionees will pay cash to the corporation to exercise their options. Other rules apply if optionees may pay the exercise price in stock.

Incentive Stock Options

1. Tax Treatment
2. Beneficial Tax Treatment for ISO Holders

The Code defines an Incentive Stock Option (an “ISO”) as “an option granted to an individual for any reason connected with his employment by a corporation, if granted by the employer corporation, or its parent or subsidiary corporation, to purchase stock of any of such corporations . . .” (Code Section 422(b)). Thus, ISOs may be granted only to employees of the corporation. Note that the Code does not specify full-time employees, so any person who receives W-2 income should be eligible to receive an ISO.

Options may qualify as ISOs and thereby receive favorable tax treatment under the Code if they meet a strict set of eligibility requirements. Options which do not meet these requirements, either at the time of grant or prior to their exercise, are deemed NSOs. (Code Section 421(b)). ISOs are not treated as ordinary income taxable in the year of the grant, as are NSOs and outright stock issuances. (Code Section 63, 64; see also Code Section 83(a)). When an option is granted pursuant to an ISO plan, no income tax is assessed against the grantee in the year of the ISO grant or at the time he or she exercises the option and receives shares of stock in the corporation. (Code Section 421(a)). Assuming the employee holds the stock purchased for the requisite holding period, generally one year, any gain from the sale will be taxed as long-term capital gain, rather than as ordinary income. Long-term capital gain is preferable to ordinary income for purposes of federal income tax because the former is subject to the favorable maximum rate of 20 percent, whereas ordinary tax rates can be much higher. (Code Sections 1, 1221, 1231) . Note, however, if the employee sells his or her stock within one year of the exercise of the ISO or within two years of the option grant, the gain will be treated as ordinary income to the employee.

2. Tax Effect on Corporation

The corporation will be unable to deduct any amount for the grant of an option pursuant to an ISO plan. (Code Section 421(a)). However, in the event that the grantee of an ISO fails to meet the holding period requirements discussed below, the corporation will be able to take a deduction in the year of exercise of the option equivalent to the income realized by the grantee. (Code Section 421(b)). Otherwise, there is no deduction allowed with respect to the “spread” between the exercise price and the fair market value at the time of exercise.

3. Alternative Minimum Tax Considerations

When an ISO is exercised, its holder may be required to pay alternative minimum tax (“AMT”) resulting from any difference between the exercise price of the option and the fair market value of the stock at the time of exercise. AMT liability can be substantial and can, in some cases, create an incentive for option holders to exercise options as soon as possible. You should note that some option holders may prefer a plan that allows them to exercise options before they are fully vested, which may be accomplished through some forms of option plans and option grants. Those mechanisms have not been included in the plan and related documents attached to this letter. See the further discussion of AMT at the end of this letter.

1. Requirements for Treatment as ISO

The requirements for a stock option grant to receive ISO treatment can be grouped into three categories: terms of grant, “disqualifying dispositions” and ceiling on exercise.

1. Terms of Grant

There are several statutory guidelines specified in Code Section 422(b) which must be followed when granting ISOs:

(a) The option must be granted pursuant to a plan which provides for the aggregate number of shares issuable under the plan and which employees are eligible to receive them;

(b) The plan must be approved by the stockholders of the granting corporation within twelve months before or after the date such plan is adopted;

(c) The option must be granted within ten years from the date the plan was either adopted or approved by the stockholders, whichever is earlier;

(d) The terms of the option must state that the option is not exercisable beyond ten years from the date the option is granted;

(e) The price of the option cannot be less than the fair market value of the stock at the time the option is granted;

(f) The terms of the option must prohibit the transfer of the option by the employee, other than by will or the laws of descent and distribution, and must state that it is exercisable only by the employee during his or her lifetime; and,

(g) At the time of the grant of the option, if the employee possesses stock that accounts for ten percent or more of the total combined voting power of all classes of stock of the corporation, its parent or its subsidiary, then the exercise price of the option must be at least 110% of the fair market value of the stock.

2. Disqualifying Disposition-Holding Period Requirement.

Stock received on exercise of an ISO will receive favorable ISO tax treatment as long as the stock has been held until the later of either (i) the date two years after the grant of the ISO; and (ii) the date one year after exercise of the ISO.

Stock otherwise qualifying for ISO treatment will lose its status as ISO stock if the holder breaches the holding period requirement. (Code Section 421(b)). In other words, if a grantee transfers shares of stock received pursuant to exercise of an ISO within either two years of the grant, or one year after the stock was purchased on exercise of the ISO, he or she has effected a “disqualifying disposition” of the stock, which precludes favorable tax treatment for stock acquired pursuant to an ISO. Instead, the amount realized by the employee from the disqualifying disposition will be taxed as ordinary income in the year it occurred. The corporation may take a corresponding deduction in the year the employee makes the disqualifying disposition. (Code Section 421(b)).

Conversely, if all requirements for a qualifying ISO are met and the grantee makes no disqualifying disposition, there will be no tax liability to the grantee until he or she sells the stock. Again, any gain realized by the grantee upon the disposition of the stock will be taxed at the more favorable long-term capital gains rate, and there will be no deduction for the employer corporation.

3. Ceiling on Exercise.

There is a $100,000 per year limitation per employee on ISO treatment of stock received on exercise of options. (Code Section 422(d)). When options become or are exercisable during a given tax year, only the first $100,000 worth of stock received on exercise of options may be treated as ISO stock for tax purposes. The excess over $100,000 will be treated as stock received on exercise of NSOs. The rule is applied to multiple option grants by disqualifying them in the order in which they were granted. The fair market value of the stock is determined as of the time the option was granted, and options do not become disqualified solely by reason of the appreciation in value of the underlying stock after the option is granted. (Code Section 422(c)).

For example, if an employee holds options to buy 50,000 shares of stock at $5.00 per share, and if the entire option is exercisable during the current year, then only 20,000 shares qualify for ISO treatment. The remaining 30,000 shares will be treated as NSO stock, even if the option holder exercises the option or a portion thereof in a subsequent year. It does not matter when the option actually is exercised, only when and to what extent it is exercisable.

Non-Statutory Stock Options

1. Definition and Typical Provisions

Non-Qualified Stock Options do not receive the favorable tax treatment of ISOs. NSOs are still highly useful, however, for attracting and keeping talented individuals because they do not have to meet specific Code requirements. NSOs have no statutorily defined holding period, term guidelines or ceilings on exercise, and they may be granted to non-employee individuals valuable to the corporation, such as outside directors and consultants.

Because the Code does not specify a holding period or other guidelines which the corporation and grantee must follow, it is possible for a grantee to exercise the option, then sell the underlying shares immediately. This would, however, run contrary to the guiding principle behind stock option plans: to encourage employees and other valued contributors to the corporation to align their interests with those of the corporation by turning such people into shareholders. Thus, NSO plans often contain repurchase provisions designed to encourage the employee to stay with the employer (or continue providing services to the corporation) for a number of years or lose some of the upside in the stock.

A common practice is to include a repurchase provision in NSO grants to persons (directors and consultants), whose positions involve service to the corporation over a term of several years. The repurchase provision gives the corporation the right, after exercise of the NSOs, to buy back some or all of the shares purchased pursuant to the NSO. Such repurchase rights generally lapse over time so long as the optionee continues in the employment of, or providing services to, the corporation. Another common type of repurchase right is one permitting the corporation to repurchase all shares on the employee’s or service provider’s termination of employment or termination of a service provider contract. In either case, once the repurchase right has lapsed, the optionee may freely transfer his or her rights in the stock. (Code Section 83(c)).

1. Tax Consequences of NSOs
2. Ordinary Income.

The grantee of an NSO may be taxed at the time of grant and upon exercise of the option. At the time of grant, the grantee will have ordinary income based on the value of the option. If the option exercise price is at or close to the fair market value of the underlying stock at the time of the option grant, the option will not be considered to have value. However, if the exercise price is a substantial discount from the stock’s fair market value at the time of grant, the option will have an independent value, taxable to the grantee and deductible by the corporation. The amount of income will depend upon the amount of the discount from the stock’s fair market value at the time of the grant, as well as upon the various restrictions that may apply to the stock received upon exercise, e.g. repurchase rights as discussed above. Generally, we encourage companies to issue NSOs with exercise prices equal to fair market value on the date of grant.

The grantee of an NSO will be taxed again at the time of exercise of the NSO, in the event that the stock has appreciated between the time of the NSO grant and the time of exercise, or under any circumstance where the exercise price is less than fair market value at the time the option is exercised. The taxable income is included in the grantee’s gross income and is subject to federal taxation in the year that the grantee acquires the stock (i.e., in the year of exercise). Taxable income is calculated by subtracting the exercise price from the fair market value of the stock at the time the stock was purchased. (Code Section 83(a)).

2. Deferral of Tax and Section 83(b).

When stock is acquired subject to vesting provisions such as repurchase rights in the corporation if the employee leaves, the tax otherwise payable upon exercise of a NSO is deferred until the repurchase rights lapse. In a corporation whose stock is expected to appreciate rapidly, this deferral of tax would result in a greatly increased tax due at the time the restriction lapses. The reason is that the taxable income is calculated as the difference between the exercise price and the stock’s fair market value at the time the restriction lapses. Under these circumstances, the employee may exercise an election to be taxed at the time he or she acquires the stock as provided in Code Section 83(b), hence an “83(b) Election”. If the employee makes an 83(b) Election, the taxable income realized at the time the stock is acquired is the last income event until the employee sells the stock. Thus, the employee holding stock for the applicable long term capital gain holding period would convert any appreciation occurring after exercise and up to the time the restriction lapses from ordinary income to long term capital gain. Option holders must file Section 83(b) elections with the Internal Revue Service within thirty days of the date the option holder has notified the corporation in writing that he or she is exercising options.

C. Alternative Minimum Tax

When an ISO is exercised, an option holder may be required to pay AMT based on the difference between the exercise price of the option and the current fair market value of the underlying stock. AMT must be paid if it exceeds the amount of ordinary income tax a taxpayer must pay. The AMT is subject to tax rates that differ from the ordinary income tax rates, and a taxpayer’s alternative minimum tax base differs from the taxpayer’s adjusted gross income for ordinary income tax purposes. The AMT base is determined by calculating AMT income, which is itself subject to a special set of rules, and then by applying a special set of AMT adjustments and items of tax preference. Many deductions allowed when determining the amount of ordinary income tax owed are not allowed when computing AMT income.

Stock option plans may be set up to allow option holders to exercise ISOs prior to vesting, which may help some option holders reduce AMT liability. If an option holder exercises an ISO before the option holder is fully vested in the shares, then the difference between the exercise price paid for those shares and the fair market value of the shares would be included in AMT income at the time the shares vest rather than at the time the option is exercised. In order to avoid being taxed on the potentially increased value of the shares at the time the stockholder is fully vested, the shareholder would make an election under section 83(b) within thirty days after exercise, in order for the difference between the exercise price and the fair market value of the shares to be included in AMT income at the time of exercise.

A taxpayer’s personal circumstances including ordinary income tax liability must be considered when determining whether AMT will be an issue. Option holders should be advised to consult with their individual tax preparers and advisers for more detailed information concerning AMT and the ramifications of AMT in connection with contemplated option exercises.

Conclusion- Designing a Stock Option Plan

Many companies adopt stock option plans as part of their compensation packages because they recognize that maintaining a talented and diligent workforce is one of the principal requirements to be a strong competitor. Stock option plans allow employees and other valued individuals a way to acquire stock ¾ hence, ownership ¾ in the corporation.

In designing a stock option program, a corporation needs to consider carefully how much stock it is willing to make available, who will be eligible to receive stock options, and how much the workforce is expected to expand. A common error is granting too many stock options too soon. In such cases, the corporation is then unable to grant options to employees in the future.

In most cases, a combination of ISO and NSO options is the best way to provide incentives for all valued contributors to a corporation. The corporation should consider its present and anticipated future needs carefully when adopting a plan. We would be pleased to share with you our experience to help you design a stock option plan that will meet the specific objectives of your corporation. Therefore, please do not hesitate to contact us with any questions you may have in adopting a stock option plan suitable for your needs.