The Internal Revenue Service (IRS) classifies stock options as either statutory or non-statutory, for federal tax income tax purposes. Statutory options, or qualified options, are incentive stock options and options issued under employee stock purchase plans. All other compensatory stock options are non-statutory or non-qualified stock options.
A non-qualified stock option allows an employee to buy a specified number of shares of its employer’s stock over a given number of years at a specified price. Thus, non-qualified options let employees participate in their employer's corporate growth, with little or no initial capital outlay, until the time the option is exercised.
Because most options granted by closely-held companies do not have a readily ascertainable fair market value at time of grant, the IRS does not tax the employee until the employee exercises the option. The IRS treats any increase in the value of the underlying stock between the time of grant and time of exercise as compensation for services and taxes it to the employee as ordinary income. The employer receives a business expense deduction for that amount. The amount of compensation equals the amount by which the fair market value of the stock at the time the option is exercised exceeds the amount paid for it (the option or grant price).
The IRS applies special rules if the stock subject to an option without a readily ascertainable fair market value is not substantially vested, that is, the employee cannot freely transfer the stock, or the stock is subject to a substantial risk of forfeiture. In that case, the employee does not realize compensation income until the restrictions are satisfied or removed. The employee may, however, elect to report the income in the year he transfers the stock despite those restrictions. There is no substantial risk of forfeiture if the employee has an unconditional right to receive stock that is not subject to any condition, or only to conditions that he may perform at any time. Thus, if the employee has the right, upon exercise of the option, to pay for the underlying stock at any time and to obtain it immediately after making payment, free of restrictions, he realizes compensation at the time of exercise.
This means that employees who receive restricted stock in connection with performing services may postpone income recognition until the stock becomes freely transferable and not subject to substantial risk of forfeiture, instead of paying taxes in the year they receive the stock. The employee pays taxes on the amount by which the value of the stock at the time it becomes substantially vested exceeds the exercise price. A special election rule allows the employee to report the income from substantially non-vested stock when received, rather than when the stock becomes substantially vested. Additionally, anyone who receives a non-statutory stock option must report the option to the IRS for the tax year in which he acquired it, even if the non-statutory option is not taxable to the recipient.
The employer generally takes a business expense deduction for the amount that the employee recognizes as compensation income. The timing of the employer's deduction is correlated with the time the employee reports the income. If the employee does not have the funds to pay the resulting tax liability, which may be substantial, he may be forced to sell the stock. Moreover, if the value of the stock received by employee appreciates by the time it becomes transferable or nonforfeitable, the IRS taxes that appreciation as ordinary compensation income, which may be subject to tax withholding, rather than as capital gain.
A mere offer to grant an option is not an option. For example, to keep a key employee, the company grants the employee an option, exercisable for a five-year period, to buy up to certain percentage of the company’s stock, if the company’s earnings increase by a certain percentage. If there is no such increase, he cannot exercise the option. In this instance, the company has given the employee no more than a conditional right to receive an option that terminates if the company’s earnings do not satisfy the condition. A similar situation arises when the company gives an employee the option to buy a certain number of shares per year over a set number of years, if annual gross profits increase by a set percentage over the gross profits for each preceding year. Again, the condition is the increase in gross profits. The company can tie the condition to any number of benchmarks, such as book value, net profits, total revenues, gross sales, or any other criteria important to the company.
Please see the following articles for additional information: Employee Stock Option Plans, Federal Securities Aspects of a Stock Option Grant, Option Plan Decisions, Stock-based Compensation, Stock Appreciation Rights, Phantom Stock, Performance Units, Non-Qualified Deferred Compensation Plans, Texas Exemption for Employee Stock Option and Similar Plans.
THIS INFORMATIONAL MEMORANDA FROM THE LAW OFFICES OF THOMAS D. SOLOMON, P.C. is provided as a courtesy to our friends and clients to provide them with items of interest in the stock option area. It is not and is not intended to be an exhaustive treatment of its subject matter, but rather an overview of the pertinent elements of such matter. It is not intended to be legal advice or a legal opinion and should not be relied on in making legal or business decisions. If you have any questions, please call us.
