Compensatory Stock Options – The Tax Traps

Stock options are a popular method of providing executive compensation for start-up or young companies.  They don’t cost the company any cash and they give the employees an incentive to make the company succeed.  But stock options come in different forms, and the form you choose can have a big impact on the tax consequences to your employees.

For tax purposes, stock options are divided into two categories – incentive stock options (“ISOs”) and other (“non-qualified”) options.

ISO’s have special status under the tax code.  An employee who receives an ISO is not taxed when he receives it or when he exercises it; he is taxed only when he sells the stock that he acquired through exercise. This delay in taxation (until there’s cash to pay the tax) is the key advantage of an ISO.

Another tax advantage of an ISO is the possibility of capital gain treatment on the entire value of the option.  If the employee sells the stock more than a year after exercise, and more than two years after the underlying option was granted (the so-called “qualifying period”), all gain is capital gain. If he sells the stock before the qualifying period expires, the “bargain purchase element” of the gain — the difference between the value of the stock at exercise and the consideration that the employee paid for it — is ordinary income. But the rest of the gain – any gain that accrues after exercise — is capital gain.

While a good deal from a tax perspective, the ISO has financial disadvantages.  For an option to qualify as an ISO, its minimum exercise price must be the fair market value of the underlying stock on the day that the option is issued (110% of that price for employees who own more than 10% of the company).  For example, if the value of the stock on the option issue date is $2, the employee must be required to pay an exercise price of at least $2 when he exercises it ($2.20 for 10%+ owners). So with ISO’s you can’t give your employee free stock. Also, the ISO must be exercised within 10 years after it is issued (otherwise the favorable tax treatment disappears).   There are also limits on the maximum stock value that an employee may receive in any year through an ISO.

“Non-qualified” stock options — options that are not ISO’s – have tax disadvantages:  they are taxed when they are issued if the value of the option can be determined at that time; otherwise they are taxed upon exercise.  As a practical matter, non-qualified options are taxed when they are exercised because, unless the option trades on an exchange, it is usually impossible to value it at issuance. In either event, there is no cash to pay the tax unless the stock is sold.  Moreover, once the non-qualified option is taxed, the bargain purchase element is always taxed as ordinary income.  However, any gain above the bargain purchase element, realized on a subsequent sale of the stock, is capital gain.

Non-qualified options have another serious tax disadvantage: unless they are exercisable at the fair market value of the underlying stock on the issue date, they may be subject to the deferred compensation penalties of the tax code.  They in fact become subject to those penalties if they don’t set an exercise date or if they permit the employee to defer exercise beyond the original exercise date (and in some cases if they permit the exercise date to be advanced).   If the deferred compensation rules apply then once the option becomes taxable the employee must pay a penalty of 20% of the bargain purchase element (plus interest on the tax that would be been due without the deferral).  ISO’s, on the other hand, are never deferred compensation as long as they satisfy certain (easily met) conditions set down in the tax code.

But non-qualified options, while considerably less attractive from a tax standpoint, don’t contain any of the restrictions placed on ISO’s.  If the employee is prepared to pay the tax on exercise and, if applicable, the deferred compensation penalty, the options can have an exercise price of zero and can be exercised whenever the employee wishes to do so (or whenever the option agreement permits).

The company that grants the option doesn’t claim a deduction for the value of the compensation represented by the option until the employee realizes income. In the case of an ISO, this is when the employee sells the stock; in the case of a non-qualified option, when the employee receives the option (if it can be valued) or (more likely) when he exercises it.  The delay in claiming the deduction may not be a disadvantage to the company since, as a start-up company, it may not have much profit before then in any event.

There is no easy answer to which form of option to issue:  it depends on the financial condition (present and expected) of the company, on who’s receiving the options (and his or her ability to pay the tax), and on what best motivates the recipient.  The important thing is to understand the consequences and make sure that the employee understands them, as well.

The information in this article is for general, educational purposes only and should not be taken as specific legal advice.

About the author

Michael Savage, Esq.

Michael Savage, Esq.

Michael Savage is principally involved in the practice of corporate and international tax planning and domestic and international mergers and acquisitions. Mr. Savage provides tax planning and acquisitions advice to U.S. taxpayers investing abroad and to foreign companies investing in the U.S. He also represents companies and individuals before the Internal Revenue Service and in the federal courts. Mr. Savage also advises foreign financial institutions on complying with U.S. securities laws governing foreign investment advisers.
Michael Savage, Esq.

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