Large companies have long used stock options to attract and retain key executives. A stock option gives an individual the right to buy company stock at a fixed price for a stated period of time. For example, assuming that Acme Co. stock is trading for $100 a share, Acme might give its executive the right to buy up to 1,000 shares of Acme stock for $100 per share at any time in the next three years. If the executive succeeds in pushing Acme's stock price up to $150 a share, he can exercise his option and acquire 1,000 shares of Acme stock (now worth $150,000) for just $100,000. That's a cool $50,000 of income for the executive and similar gains for Acme's other shareholders.
Led by the high-tech sector, more and more companies are using stock options to attract and motivate employees at all ranks. Indeed, according to a recent study by the human resources consulting firm of Towers Perrin, more than 11 million employees of U.S. companies are now covered by some kind of stock-based incentive plan, with stock options by far the most common type of incentive.
The taxation of stock options is governed by an unusually complicated set of federal tax rules. These rules determine whether an option will be taxed when it is granted to an employee, when the option is exercised by the employee, or only when the employee sells the stock itself. Special rules also determine the extent to which any gain from the sale of the stock is eligible for the 20 percent maximum tax rate on capital gains.
The federal tax code provides for two general types of employee stock options: nonqualified stock options and qualified stock options.
Nonqualified stock options are the most common. As with any stock option, a nonqualified stock option gives the employee the right to buy company stock at a fixed price for a stated period of time. In general, under code section 83, an employee has ordinary income whenever his employer gives him a valuable economic benefit as compensation for services. Under this approach, an employee has income equal to the fair market value of a nonqualified stock option when that option is granted to him. And the employer deducts that same amount as compensation for services paid to the employee (under code section 162).
For example, if Acme gives its executive an unrestricted right to buy up to 1,000 shares of Acme stock for $90 a share at a time when the stock is trading for $100 a share, the executive should report $10,000 in income (1,000 x [$100 - $90]), and Acme can deduct $10,000 as compensation paid.
If the nonqualified stock option does not have a readily ascertainable fair market value at the time of the grant however, the employee does not have to report any income at the time of the grant. Instead, when the option is exercised, the excess of the fair market value of the stock acquired over the option price will be included in the employee's gross income. And the employer will deduct a like amount at that time.
For example, if Acme gives its executive the right to buy up to 1,000 shares of Acme stock for $100 a share when the stock is trading for $100 a share, the executive typically will not report any income at the grant of the option (and Acme will take no deduction). Instead, assuming that the executive later exercises the option when the Acme stock is trading for, say, $150 per share, the executive will then include $50,000 in income (1,000 x [$150 - $100]), and Acme will then deduct $50,000 as compensation paid.
Alternatively, an employer might want to provide its employees with a qualified stock option. With qualified stock options, no amount is includable in the gross income of the employee at the grant of the option, or at its exercise. Instead, the employee waits until he sells the underlying stock to pay any tax, and then all of his gain will be taxed as a capital gain. …