Stock options may comprise a significant portion of compensation to key employees. Incentive stock options (ISOs) are subject to various nontax requirements, e.g., that the options be granted within 10 years of plan adoption, that they be exercised within 10 years of the grant date, and that the strike (exercise) price equal or exceed the stock’s FMV at the grant date. Stock options that do not qualify as ISOs are referred to as “nonqualified stock options” (NQSOs), and receive less favorable tax treatment.
Assume XYZ Corp. issues 100,000 ISOs with an exercise price of $12 to Executive when the stock is trading at $10. When the stock reaches $15, Executive exercises all 100,000 options. A year and a day later, when the stock is trading at $20, Executive sells the stock.
No tax occurs when the stock options are granted. Upon exercise, no regular tax event occurs, but an AMT tax preference of $300,000 is created on the difference between the FMV of the stock and the exercise price [($15 – $12) x 100,000]. If Executive is subject to AMT, the AMT tax cost would be $84,000. When the shares are sold, a long-term capital gains tax of $75,000 would result [($20 – $15) x 100,000 x 0.15]. When the shares are sold, a negative AMT preference would be available to offset AMT if Executive were subject to AMT in that taxable year.
If a year and a day after exercise the stock were instead trading at $11, which is lower than the exercise price, Executive could sell the stock and claim a $1 per share long-term capital loss for regular tax purposes ($12 – $11) or a $4 per share AMT loss ($15 – $11). If, alternatively, the trading price a year and a day after exercise were $14 — which is higher than the exercise price but lower than the trading price when option was exercised — a long-term capital gain of $2 per share would be reported for regular tax purposes ($14 – $12), but a capital loss of $1 per share for AMT purposes would result ($15 – $14).
The grant of a NQSO is also not a taxable event if there is no readily ascertainable FMV, which is usually the case. However, the exercise of nonqualified stock options results in ordinary income in the year of exercise (rather than merely an AMT tax preference as with ISOs) equal to the excess of the FMV of the stock at the time of exercise over the strike price. In the first example, upon exercise, a tax liability of $105,000 would result [($15 – $12) x 100,000 x 0.35]. Upon eventual sale of the stock (after a year) long-term capital gain treatment would be available.
To induce loyalty of employees, compensation may take the form of restricted stock subject to a substantial risk of forfeiture if the employee terminates service. Under IRC § 83(a), which governs property received for services, no taxable event occurs upon receipt of restricted stock. However, when the restrictions lapse (e.g., at IPO), employee must report ordinary income equal to the difference between the FMV of the stock and the price (if any) paid for the stock. Long-term capital gain treatment will be available for reporting subsequent stock appreciation.
Ordinary income tax liability upon lapse of the restrictions can be avoided by making an IRC § 83(b) election when the option is granted. With a § 83(b) election, the FMV of the restricted stock is reported as income when received. When the restrictions lapse, no taxable event occurs. A capital gains tax is imposed when stock is eventually sold. Two disadvantages with the election are first, that tax must be paid currently rather than when the restrictions lapse and second, that if the stock is forfeited, no tax loss will be available. [Note that a § 83(b) election is not available for stock options, because they are not considered “property” under the Code.]