A Primer on Stock Option Compensation

2/1/2008

Equity compensation is noncash compensation that transfers an ownership interest in the business to an employee or other service provider and can be an effective means to hire, motivate and retain key employees. Businesses may be attracted to this form of compensation because it does not require a cash outlay. Employees may prefer the favorable tax treatment associated with equity compensation plans. The following discussion briefly summarizes certain aspects of one of the more common forms of equity compensation: stock options.

A stock option is the right to acquire a certain number of shares of stock for a specific price (exercise price). The intrinsic value of an option is derived from the difference between the fair market value of the underlying stock and the exercise price of the option (the spread at exercise). When stock options are granted to employees, the right to purchase stock is typically not immediately exercisable but rather vests or accrues over a period of time or upon meeting certain company performance goals. This vesting feature encourages employees to remain with the company for the duration of the vesting period and/or help the company meet its goals.

There are two forms of stock options: incentive stock options (ISO) and nonstatutory or nonqualified stock options (NSO). ISOs are different from NSOs in that ISOs receive favorable federal tax treatment if the option meets certain requirements of the Internal Revenue Code.

When granted, both ISOs and NSOs should have an exercise price that is not less than 100 percent of the fair market value of the underlying stock. Generally, neither ISOs nor NSOs are taxable upon grant to the employee or when the option vests. The difference in taxation is upon the exercise of the option. When an NSO is exercised, the employee recognizes compensation (ordinary) income in an amount equal to the spread at exercise. An employee does not recognize taxable income on exercise of an ISO. However, the spread at exercise is includible in the employee’s federal alternative minimum taxable (AMT) income and may give rise to AMT tax liability.

If stock acquired upon exercise of an NSO is held for more than one year, any gain realized on the disposition of the stock is taxed at favorable long-term capital gain rates. ISOs must be held for at least two years from the date of grant and at least one year from the date of exercise to qualify for favorable capital gain tax rates. Otherwise, the employee recognizes compensation income that is taxed at ordinary income tax rates.

The different aspects of ISOs and NSOs provide flexibility in tailoring an equity compensation plan to fit a company’s needs. Given the complex legal, accounting and tax issues, a company should seek advice before implementing an equity compensation plan.

Mark L. Astling is a tax attorney at the business law firm of Stoel Rives LLP (www.stoel.com), where he advises a wide variety of corporate and pass-through entities, as well as individuals, on federal, state and local tax issues. Mr. Astling can be reached at mlastling@stoel.com or (801) 578-6983.

This column is not to be considered legal advice or a legal opinion on specific facts circumstances. The contents are intended for informational purposes only. If you need legal advice or a legal opinion, please consult with your attorney.

Originally appeared in Business Connect magazine, February 2008.