Incentive and Non-Qualified Stock Options

Viewpoints on Financial Planning
Managing the wealth potential of employee stock options is complicated, but affords significant appreciation potential.

Employee stock options are a right (grant) given by a corporation to a group of employees to purchase its stock at a future date for a fixed share price. Over the last few decades, share ownership by employees has become a more common attribute of major American companies. This distribution of share ownership is part of the belief that employee share ownership provides a benefit to the business as it encourages employees to think and act as owners.

With a stock option, the employee can, but is not obligated to, exercise the option and purchase the stock. Because stock options afford the option holder a time period (usually several years) to decide when and if to exercise the option, they are viewed quite favorably by the employee population as they can benefit from any price appreciation with no immediate cash outlay. In many cases, possessing a stock option may be better than owning the stock individually. Not only can an option holder benefit from a substantial source of deferred income and control the recognition of such income at least through the exercise period, they are also protected from loss should the share price decline below the exercise price as there is no cash outlay until the option is exercised. Also, all post-exercise growth is taxed as capital gains rather than ordinary income—with long-term capital gains eligible for 15% for most clients (20% for taxpayers in the 39.6% federal income tax bracket, plus state income tax, if any) versus a 39.6% top rate for ordinary income, which can be a significant benefit.

An option holder can choose to exercise the option at any time during the exercise period. If the stock price exceeds the exercise price, the option is considered to be “in the money” or “above water,” allowing the option holder to essentially purchase the stock at a discount. On the other hand, where the exercise price is greater than the price of the stock in the open market—the option is “out of the money” or “under water.” In such a situation, the option holder would let the option expire without exercising, absent a situation where the company is private, and exercising the option might be the only way to acquire the underlying stock.

There are two types of employee stock options: incentive (ISO) and non-qualified stock options (NQSO). While they operate in a similar manner, the underlying income tax treatment of each is markedly different relative to timing of the income reportable and the tax consequences thereon (ordinary income versus long-term capital gains). In addition to understanding the type of option, it is also important to know when the option can be exercised, the tax consequences at that time and the methods of funding the purchase price.

Clearly, a prudent strategy for managing the wealth associated with stock options requires knowledge of the type of option, terminology, time period for exercise, the tax consequences and the method of funding the purchase price.

1. What communication do employees generally receive when they are granted a stock option?

An employee will receive a Stock Option Grant Certificate and Agreement that will typically include the following:

  • Type of option: ISO or NQSO
  • Terms of the option: number of shares subject to the option, exercise (purchase) price per share, grant date, expiration date (when the option purchase right expires), vesting schedule (how long must one wait to exercise the option)
  • Income tax consequences of the option (ISO and/or NQSO)
  • Tax (federal income, Social Security, Medicare, state and local income tax) and withholding requirements, if any
  • Restrictions, if any, on transferability of the options or perhaps federal or state securities laws
  • Impact, if any, on the stock option terms due to corporate events (mergers, sales, stock splits, etc.)
  • Effect, if any, on the stock options upon employee’s termination of employment (death, disability, retirement, separation of service, etc.)

2. What are the requirements and tax ramifications associated with the grant and exercise of an ISO, and tax ramifications associated with the sale of the underlying stock?

To be treated as an ISO, several requirements must be met:

  • An ISO can only be granted to employees.
  • An ISO cannot be transferred during the lifetime of the employee.
  • An ISO may not be exercised more than 10 years from the date the options were granted. For 10% shareholders, the maximum exercise period is shortened to five years.
  • The option exercise price may not be less than the fair market value (FMV) of the stock, determined at the time the option is granted. For 10%+ owners of the company, the exercise price must equal 110% of the FMV at the time of grant.
  • There is a $100,000 limit on ISOs that become exercisable for the first time in any calendar year. This limit is based on the value at the time of grant and not at exercise. Any excess beyond the $100,000 limit as measured at the time of grant would be treated as an NQSO.
  • The employee must be employed for the period beginning at the option grant and ending three months before the exercise. Special rules are in place in case of the employee’s death, disability or leaves required by statutes (e.g., the Family Medical Leave Act).

If these requirements are satisfied, neither the grant nor exercise of an ISO would have any tax consequences for regular income tax purposes. However, the difference at the time of exercise between the exercise price and fair market value (FMV) increases a taxpayer’s alternative minimum taxable income in the year of exercise and may trigger an alternative minimum tax liability. A sale of the stock acquired through exercise of an ISO is eligible for favorable long-term capital gains treatment measured by the difference between the sales price received and the exercise price paid.

To qualify for this favorable tax treatment, the option holder must 1) own the shares for more than a year; and 2) the stock cannot be sold within two years of the date of grant. If either of these tests is not met, the ISO would be treated as a disqualifying disposition, and therefore subject to most of the nonqualified stock option income tax rules (see FAQ #3). This means ordinary income on the difference between the FMV at exercise and the exercise price. The difference between the sales price received and the FMV at the time of exercise is treated as a capital gain, long- or short-term, depending upon the holding period prior to sale. But unlike an NQSO, there is neither income nor FICA tax withholding applicable to a disqualifying disposition upon exercise of an ISO.

3. What are the requirements and tax ramifications associated with the grant and exercise of an NQSO as well as the ultimate sale of the underlying stock?

All other employee stock options that are not ISOs are NQSOs. An NQSO gives an employee the option to buy corporate stock at a fixed price (usually equal to the FMV at the time of grant). There are no tax consequences on the grant while the spread or difference between the FMV at exercise and the exercise price is taxed as ordinary income and is also subject to FICA (Social Security and Medicare) tax withholding. Any gain realized upon subsequent sale is taxable as a capital gain, long- or short-term depending upon the holding period.

On exercise of an NQSO, the company gets a tax deduction equal to the compensation (stock price appreciation) reported by the employee. There is no such tax deduction for the company with an ISO unless the employee makes a disqualifying disposition. This is why NQSOs are more commonly used in corporate America.

The wealth potential from a NQSO can be substantial. The following example illustrates this clearly.

Example: Jack receives NQSOs granting him the right to purchase 1,000 shares of ABC stock at $50 per share. Twenty-four months later, the share price has reached $120 per share. The market value of the stock on that date is $120,000. Before taxes, Jack has increased his net wealth by $70,000 with none of his money at risk.

4. What steps should one take when executing a plan for managing employee stock options?

In formulating any stock option strategy, it is important to remember that option holders are employees and/or directors of the company and can find it difficult to be objective about the prospects of their respective company. Accordingly, an objective approach that encompasses an analysis and assumptions relative to future stock price, dividend rate and growth should be utilized.

Step 1: Determine how best to optimize the option holder’s wealth consistent with risk temperament, and personal and financial goals. The strategies will generally fall into one of these categories:

  • Increased holdings in the company stock
  • Diversification of the overall portfolio, and potential concentrated stock risk and return
  • Capture of profit for personal consumption or needs

Step 2: Determine the best time to exercise the option. Since most options become exercisable over a period of years, it is imperative to know the timetable available under the plan document.

Step 3: Understand what cash needs the option holder might have in the period prior to option expiration. The greater those needs relative to existing personal liquidity, the increased likelihood the option holder should sell and realize the profit in the option in the short- to intermediate-term.

Step 4: Determine the expected performance of the stock relative to its current value, and how that might be impacted by general market performance. Generally, if the stock that underlies the option is expected to appreciate significantly it is beneficial to defer exercise to lessen portfolio risk and maximize returns; however, this must be weighed against the benefits of portfolio diversification.

Once the strategy is in place, the next decision is how to exercise the option. The most straightforward approach is to pay cash for the option and either hold the stock (exercise and hold) or sell some or all of the stock to cover the exercise price and any tax withholding. This is referred to as a cashless exercise. In some cases, an option holder might sell the shares immediately (exercise and sell) to either diversify his or her asset holdings, or for consumption reasons. Finally, some plans allow the option holder to swap existing shares to exercise additional option shares.

5. Is it possible to gift an employee stock option to others? If the answer is yes, what are the income and transfer tax consequences?

If the plan document permits, an option holder can gift an NQSO. There is no ability to gift an ISO. Under current law, only vested NQSOs can be treated as completed gifts so as to remove the option wealth and potential appreciation from the taxable estate. The valuation of the gift must be done utilizing a generally recognized option pricing model such as the Black-Scholes model.

The factors to be considered in this valuation calculation include: the option’s exercise price; the option’s expected life; the current trading price of the underlying option; the expected volatility of the underlying stock; the expected dividends of the underlying stock; and the risk-free interest rate over the remaining option term. Regardless of gifting the option, the option holder remains fully responsible for the income tax liability upon option exercise. This should not be viewed as a negative from a wealth transfer perspective as the payment of income taxes can be viewed as an additional tax-free gift to one’s heirs.

SUMMARY

Clearly, managing the wealth potential of employee stock options is complicated, but affords significant appreciation potential. In addition to seeking to minimize taxes and financing costs, option holders can often benefit from optimizing tax deferral in light of company specific and overall financial market performance. The key is to develop a well thought out strategy and not let day to day stock or market performance guide the decision-making process.

January 2013

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