Stock options are a popular choice for corporate employers that desire to grant their employees incentive compensation. This makes sense. They afford such employers a means to compensate key employees with an award that increases in value to the employee as the corporation’s value increases, and they give employees flexibility with respect to whether and when to incur a personal tax liability. Further, they are a well-known form of compensation and considered easy for employees to understand.
What are Stock Options?
A stock option is not an outright grant of the corporation’s shares. Rather, a stock option entitles the employee to receive shares in the corporation if the employee exercises the stock option during a pre-determined period and the employee pays the applicable exercise price. A stock option may be exercisable immediately upon grant, but more often it will become exercisable later if the employee remains employed for a required period and/or certain business performance criteria are achieved (e.g., EBITDA reaches a targeted level).
Once the stock option becomes exercisable, the employee may then elect to exercise the stock option at any time during the remainder of the stock option term, which is typically ten years following the date of grant (or, if sooner, upon, or shortly following, the employee’s termination of service with the employer). At the time of exercise, the employee must pay the exercise price for the stock option, which for various tax reasons, should equal at least the fair market value of the employer’s shares on the date the stock option was granted. Except as described below, the employee will owe income tax at the time of the stock option’s exercise. The employee has no tax liability with respect to a stock option unless the employee exercises the stock option.
What are the Alternatives for a Stock Option Award?
There are two types of stock options: (1) those that qualify as “incentive stock options” (also known as “ISOs”) under Internal Revenue Code Section 422 and (2) those that do not qualify as ISOs (also known as “non-qualified stock options” or “NSOs”). ISOs offer attractive tax benefits. In general, an ISO holder does not owe tax at the time the holder exercises the ISO. Instead, if the ISO holder holds the ISO for one year after exercise (and two years after grant), the holder will only need to pay tax at the typically lower capital gains rate when the holder ultimately sells the shares. There is an important exception if the employee is subject to the alternative minimum tax (also known as “AMT”), which is a parallel tax system aimed at high income taxpayers that limits their ability to take advantage of certain tax deductions, credits, and exemptions. If the employee is subject to the AMT, the difference between the ISO’s fair market value at exercise and the exercise price is included as a tax adjustment at the time of exercise for purposes of calculating the AMT for the year of exercise.
If the ISO holder exercises the stock option before this holding period expires, then the stock option will be taxed as an NSO (meaning the employee will owe income tax at the time of exercise of the option). The holding period requirement makes the ISO award less practical for non-public corporation’s because the holder often does not have an incentive to exercise the stock option until there is a liquidity event such as a company sale because there is no market in which to sell the shares. In such case, the holder will often exercise the stock option and then immediately sell it without holding the stock option for the required one-year period.
For a stock option to qualify for the favorable tax treatment described above, the stock option must comply with several requirements in addition to the holding period requirement just described. Chief amongst these is the $100,000 per year limitation. Under this rule, if the aggregate fair market value of the stock with respect to which the ISO is exercisable for the first time by any individual during any calendar year exceeds $100,000, the portion of the stock option that exceeds that value is treated as an NSO and the employee will need to pay ordinary income tax on exercise for such portion of the stock option.