Stock Options 101

Anyone associated with the high tech industry has heard about employees and company founders making millions with stock options. A stock option is merely a contract between a company and a person that grants the person the right to buy shares of stock from the company in the future at a currently established price, called the exercise price or strike price. Options are typically granted to employees, directors and consultants as incentive compensation. Many have heard of "Incentive Stock Options" or "ISOs." ISOs are specially created under the Internal Revenue Code to provide favorable tax treatment (for the employee) for options granted to employees, so long as statutory requirements are met. It is unfortunate that ISOs are named "Incentive Stock Options" because, as stated, most options, whether they meet the statutory requirement for ISOs or not, are granted as "incentive compensation." All options that are not ISOs (often granted to non-employee directors or consultants) are generally referred to as "non-qualified options."

Consider the following example of an ISO option grant. Company enters into a stock option agreement with an employee on January 1, 2000 granting the employee the option to purchase 1,000 shares of company common stock at a strike price of $10.00 per share. Assume that the fair market value of the stock on January 1, 2000 is $10.00. (The company could grant the option at a strike price above or below the fair market value, but then the option would not be an ISO). Assume further that the option "vests" over a period of 5 years at a rate of 20% per year, and that the term of the option is 10 years. The relevant option terms can be summarized as follows:

Grant date: January 1, 2000

Shares: 1000

Strike Price: $10 per share

Vesting: 20% per year for 5 years, starting on 1st anniversary of Grant Date

Term: 10 years

Once an option vests, the employee may "exercise" the option and purchase the stock at the strike price or hold the option. Likewise, if an employee terminates their employment prior to the option vesting, the employee loses the option for the unvested shares. Under the vesting schedule in the example above, on January 1, 2001, 20% of the option shares vest and the employee may then partially exercise the option and purchase 200 shares of Company common stock for $10 per share, regardless of the market price at the time of exercise. After 5 years, all of the option shares will have vested and the employee may still hold the option for another 5 years prior to exercising the option. Once the option is exercised and the employee purchases the stock, he or she may hold the stock or sell it.

It is very important for option recipients to analyze the tax issues to determine when to exercise all or part of an option and also when to sell the shares received upon option exercise.

There is no tax consequence to the employee when an ISO is granted. The gains or losses on the stock between the date an ISO is granted (the "grant date") and the date the stock is purchased pursuant to the option (the "exercise date") are treated as long-term capital gains or losses when the stock is sold, so long as the employee holds the purchased stock until the later of one year after the exercise date or two years after the grant date. Long-term capital gains are taxed at a maximum rate of 20 percent, a lower rate than ordinary income, depending on the option recipient’s income and individual tax situation. ISOs, however, may be subject to the alternative minimum tax.

Furthermore, taxation of ISOs is deferred until the recipient actually sells the stock. The Company does not take a tax deduction for stock gains under an ISO. Failure of the recipient to meet the ISO holding period requirement results in taxation, at the time of sale of the stock, as if the option were a non-qualified option.

The following shows the taxation of an ISO based upon the example above:

January 1, 2000 -- Options for 1000 shares granted (Grant Date), $10 strike price. Market value is $10 per share.

January 1, 2005 -- Fully Vested

January 1, 2006 -- Employee exercises options and purchases 1000 shares at $10 per share (Exercise Date). Market value is $50 per share, tax is deferred on whole $40 increase in value.

July 1, 2007 -- Employee sells the 1000 shares at market value of $70 per share and pays long-term capital gains tax on $60 per share in 2007.

Like an ISO, there are no tax consequences to the recipient when the non-qualified options are granted (unless the option itself is actively traded on an established securities market). When the recipient exercises his or her options, however, the difference between the strike price and the fair market value of the stock is treated as ordinary compensation income to the recipient in the year the option is exercised. The fair market value on the exercise date becomes the cost basis of the stock for capital gains tax purposes. When the recipient sells the stock, the spread between the cost basis and the sales price is taxed as either a short-term capital gain taxable at ordinary income rates (if the employee held the stock for less than one year after exercise) or a long-term capital gain (if the employee held the stock for more than one year after exercise).

Using the same example, we show the tax consequences of a non-qualified option:

January 1, 2000 -- Options for 1000 shares granted (Grant Date), $10 strike price. Market value is $10 per share.

January 1, 2005 -- Fully Vested

January 1, 2006 -- Employee exercises options, purchases 1000 shares at $10 per share. Market value is $50 per share. Employee pays ordinary income tax (including Social Security Taxes) on $40 increase per share in 2006.

July 1, 2007 -- Employee sells the 1000 shares at market value of $70 per share, and pays long term capital gains tax on $20 ($70 minus $50) per share in 2007.

ISO may be granted only to employees. ISOs must be granted by agreement between the company and the employee pursuant to a written plan that is adopted by the shareholders of the company. No ISO plan or agreement may be effective for more than ten years. ISOs may not be transferred to any other person (except under limited circumstances at death), and must be exercised within three months of termination of employment.

The exercise price for an ISO must be the fair market value of the stock at the grant date or 110% of fair market value if granted to an employee that is a 10% or greater shareholder.

ISOs may incorporate "vesting" schedules as incentives for employees to remain employed with the company, but these are not required. A typical schedule will vest the options in equal increments over a specified period of time. Vesting may also be made contingent upon achievement of specific business or other performance goals. In no event, however, can more than $100,000 worth of ISOs first become exercisable in any one calendar year.

Because none of the ISO requirements discussed above applies to non-qualified options, they are more flexible than ISOs. For example, non-qualified options have no holding period requirement, may be granted to non-employees, may use an option price lower than fair market value, may be transferrable, and may contain vesting and other provisions, including any provisions that an ISO may have.

The foregoing is a general overview comparing the tax treatment and requirements of ISOs and non-qualified stock options used to determine the type of option desired. The type of option chosen, however, may have accounting and securities regulation implications for the company. The company should consult with its accountant and securities counsel regarding these implications before granting options. A recipient should consult with his or her tax advisor before exercising an option grant.