Volume 12 Issue 3 -- May/June 2000
As explained before, our main function is to provide tax and business research-planning services to tax professionals; this free newsletter is the "hook," so to speak, to get you to use our service.
Recently, one of our clients needed a primer on Incentive Stock Options (ISOs) versus Non-Statutory Stock Options (NSSOs). ISOs are relatively new compared with NSSOs, but we'll begin with NSSOs since the basic IRS guidance, Reg. Sec. 1.83-7, Taxation of nonqualified stock options, has tentacles which wrap around ISOs. This newsletter covers the basics of NSSOs and is not meant to explore all the nuances of this area. For a much more detailed and technical analysis of these two types of stock options, click here.
Blue, Inc., a hypothetical employer, wants to give some of its employees the right to own stock if they stay with the company for a stated time, say four years. Rather than issue the stock outright, the employees are given a contractual right to buy Blue, Inc., stock. This right, or option, is deemed "property" received for services and may be taxable income to Zed, our hypothetical employee, either when received or at some future time.
Here, we are assuming that the option, the right to buy stock, or the stock itself, could be subject to a restriction or forfeiture if Zed leaves Blue, Inc., within four years of the time the option is granted. Thus, what Zed receives is not fully "vested" until the four-year period expires.
Simply getting a stock option is usually not a taxable event unless the option has a "readily ascertainable" fair market value (RAFMV). Typically, only options that are separately traded on established markets have a RAFMV and are subject to taxation as income when received.
Options (here, the right to buy stock) and the stock itself, received in exchange for services, are commonly subject to taxation when the restrictions, if any, lapse. Thus, the receipt of stock (or other property) for services is not taxable if there are substantial restrictions on transfer or the property is subject to a substantial risk of forfeiture.
When Do Options Get Taxed?
Options are taxed when unrestricted property rights vest or when the restrictions on the enjoyment of the property lapse. Keep in mind that the option (as opposed to the stock it may eventually allow one to buy) has a value independent of the stock. The difference between Zed's option price and the FMV of the Blue, Inc., stock can be taxed (under an election discussed below) before the restrictions lapse.
Suppose that, in 1997, Zed is given an option to purchase stock in Blue, Inc., when the stock has a FMV of $100 per share while the exercise price of the option is $45. If the option itself has no RAFMV, the grant of the option will not be taxable. If the option has a readily ascertainable FMV (for example, it's publicly traded), the $55 difference could be taxable income to Zed and subject to withholding taxes in 1997.
Suppose the option does not have a readily ascertainable value and that Zed exercises it in 1998, when the stock is worth $200. If the stock is not subject to further restrictions (or if they have lapsed), Zed has ordinary income of $155 in 2000 ($200 - $45, the amount paid for the option). If the stock is subject to substantial restrictions, then there will be no taxation until the restrictions lapse.
If Zed holds his restricted Blue, Inc., stock until 2002 (when the restrictions lapse) and the stock is worth $250, he has ordinary income of $205. Is there a way for Zed to reduce his ordinary income tax? Yes!
Zed can elect, under IRS Code Sec. 83(b), to have the ordinary income portion of the option taxed in the year the option is exercised, 1998, at which time the spread between the option price and the FMV of the stock was $155. This $155 would be ordinary income subject to withholding for Zed and Blue, Inc.
The advantage of the election is that if Zed sells the Blue, Inc., stock in 2002 for $250, he has a capital gain of $50 ($250 - $200), which will be taxed at a lower rate. Thus, by electing earlier taxation of the ordinary income portion, Zed can convert a portion of what would otherwise be ordinary income into capital gain.
This works well when the value of the stock increases. If the value of Blue, Inc., stock declines, the election would be an unfortunate choice. Remember, this treatment relates to NSSOs. ISOs are different and will be covered in the next issue.
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