Tax & Business Professionals, Inc.

The Taxation of Employee Stock Options

In an economy driven by e-commerce, the use of employee stock options has become an increasingly significant component of many employees’ compensation.  In a June 13, 2000, article written by Gretchen Morgenson, the New York Times On the Web reported, for example, that the number of employees receiving stock options has now grown to about 10 million, up from about 1 million in the early 1990’s.

While there are many different types of stock option plans, most plans involve many of the same basic elements.  From a tax standpoint, however, there are two fundamentally different types of stock options -- so-called qualified stock options or “Incentive Stock Options” (“ISO’s”) and non-statutory or non-qualified options, sometimes referred to as “NSO’s.”  While some plans may involve both types of options, there are two different sets of tax rules applicable to these two different types of options, ISO’s and NSO’s.  For a more abbreviated discussion of the taxation of stock options, click here.

Typical Stock Option Plans

Regardless of whether the plan is an ISO or NSO for tax purposes, many plans will involve similar basic features.  The employee will be granted options to purchase company stock.  These option grants will usually be tied to a schedule or set of other conditions, which will allow the employee to exercise the option (i.e., to purchase company stock) in accordance with the schedule or the other conditions.  Typically, the option will give the employee the right to purchase company stock at the fair market value of the stock at the time of the grant of the option.  Thus, if the value of the stock rises between the grant of the option and the exercise of the option, the employee effectively gets to purchase the stock at a discount.

It is also common for plans to place significant restrictions on the stock that employees acquire through the exercise of the options.  These restrictions can take many forms, although common restrictions might include a limitation on the ability to transfer the stock (either for a stated period of time or so long as the employee remains an employee) or requirements that the employee must sell the stock back to the company at the employee’s cost if the employee leaves the company before a stated time interval.

For tax purposes, stock option plans raise a number of questions.  For example, is the grant of the option a taxable event?  Is the exercise of the option taxable?  If not, when is the transaction subject to tax?  One key difference between ISO’s and NSO’s is that the timing of the taxable events may be different.

In order to put the tax rules relating to stock options in a more concrete setting, the following discussion will consider the a hypothetical Stock Option Plan (“the Plan”).  The Plan is set up by BigDeal.com, a fledgling Internet company that provides purchasing services for businesses.  BigDeal.com’s Plan grants certain key employees the right or option to purchase 25,000 shares of the Company’s stock at a price of $1.00 per share.  As to each option, one half will be ISO stock and one-half will be NSO stock. At the time the option is granted, BigDeal’s stock is worth $1.00 a share.  Employees receiving these options are entitled to exercise options with respect to 5,000 after the close of each year of service.  Thus, after the first year, an employee can purchase 5,000 shares at $1.00 per share.  After the second year of service, an additional 5,000, and so on after each additional year until the options for the full 25,000 shares vest.

Upon exercise, the stock acquired through BigDeal’s Plan are subject to a number of explicit limitations and restrictions, including both broad limitations on the right to transfer the stock and a right of the Company to repurchase "unvested" shares at the option exercise price, if the employee leaves BigDeal.  Under the provisions of the Plan, once the options are exercised, 25% of the stock becomes "vested" (i.e., free of all restrictions) after each year of service as an employee of BigDeal.com.  For this purpose, the term "vested" means that the stock is no longer subject to restrictions.

As noted above, for tax purposes there are basically two types of stock options – ISO’s and non-statutory options (NSO’s).  Each type has its own set of tax rules.  The basic treatment for ISO's is governed by I.R.C. § 421, while non-statutory options are governed by I.R.C. § 83.  Because the non-statutory option rules are the default, it is convenient to begin by discussing those rules.

Non-statutory Stock Options

The tax treatment of non-statutory or non-qualified stock options is governed by the set of rules under I.R.C. § 83, which apply generally to the receipt of property in exchange for services.  Under § 83(a), taxable events occur only when unrestricted property rights vest or when restrictions on the enjoyment of the property lapse.   Section 83(a)(1) actually states this in terms of saying that the fair market value of property received for services must be recognized “at the first time the rights of the person having the beneficial interest in such property are transferable or are not subject to a substantial risk of forfeiture, whichever occurs earlier.”  Thus, the receipt of property, whether stock options, stock, or other property, is not taxable if there are substantial restrictions on transfer and it is subject to a substantial risk of forfeiture.  

The application of § 83 to the issuance of stock options is governed largely by Regs. § 1.83-7.  Under I.R.C. § 83(e)(3) and the Regulations, the grant of a stock option can never be a taxable event (even if the other requirements of § 83(a) would be applicable) unless the option has a “readily ascertainable fair market value.”  If the option does have a readily ascertainable fair market value, then, as the Regulations state, “the person who performed such services realizes compensation upon such grant at the time and in the amount determined under section 83(a).”  Regs. § 1.83-7(a).  In that event, the difference between the fair market value of the option and the option exercise price (or other consideration paid) will be taxable as ordinary income and will be subject to withholding. Id.

On the other hand, if the option has no readily ascertainable fair market value, the grant of the option is not a taxable event, and the determination of the tax consequences is postponed at least until the option is exercised or otherwise disposed of, even if  “the fair market value of such option may have become readily ascertainable before such time.” Regs. § 1.83-7(a).  In other words, if the grant of the option is not a taxable event, then the exercise of the option will be treated as a transfer of property under § 83. 

Obviously, the critical factor in applying § 83 to stock options is the concept of “readily ascertainable fair market value.”  Note that it is the value of the option not of the stock that is important.  Whether an option has a readily ascertainable fair market value is determined under Regs. § 1.83-7(b).  In basic terms, unless the option itself (as distinguished from the stock) is traded on an established market, an option will not usually be treated as having a readily ascertainable fair market value. Regs. § 1.83-7(b)(1).  There is a possibility, under Regs. § 1.83-7(b)(2), that certain options not traded on an exchange might be treated as having a readily ascertainable fair market value, but that rule would not likely be applicable except in relatively unusual circumstances.

Thus, in the case of options which themselves are not regularly traded, the grant of the option will not be taxable, and the tax consequences will be postponed at least until the option is exercised or otherwise disposed of.  While the taxable income, determined at the time of exercise, will be treated as ordinary income subject to withholding, any additional appreciation in the value of the stock after a taxable exercise of the option may qualify for capital gain treatment, if the capital gain holding requirements are met.

For example, in this situation, suppose that options to purchase BigDeal.com stock are exercised at a price of $1.00 a share.  If, at the time of exercise, the fair market value of BigDeal.com stock is $2.50 per share, then $1.50 per share (the difference between the fair market value of the stock and the exercise price) would be treated as compensation income.  If the stock is held for more than one year and subsequently sold for $4.00 per share, the additional $1.50 per share of appreciation can qualify for capital gain treatment.

The foregoing analysis has assumed that the stock acquired through the exercise of the option is otherwise unrestricted property -- i.e., that the stock is freely transferable and not subject to a substantial risk of forfeiture.  Here, in the case of BigDeal, there are restrictions on the transferability of the stock, and BigDeal.com has a right to repurchase the stock until the stock becomes vested.  Note, apart from the terms of a stock option plan, federal or state law may impose other limitations on transfer of the stock, such as restrictions on certain short-swing profits imposed by § 16 of Federal Securities Exchange Act of 1934. See I.R.C. § 83(c)(3).

In this instance, the repurchase right effectively requires the employee to resell to BigDeal.com any “unvested shares” purchased, at the price paid by the employee in the event of the employee's cessation of services.  Under Regs. § 1.83-3(c), this repurchase right would probably constitute a “substantial risk of forfeiture.”

Because of the existence of the repurchase right and the general restrictions on the transfer of the stock acquired through the exercise of the options, § 83 likely would not apply until such time as the restrictions lapse and the stock becomes "vested" -- i.e., no longer subject to the repurchase right.  In other words, because of the limitations on transfer and the presence of a substantial risk of forfeiture, the exercise of the BigDeal.com option and the acquisition of the restricted stock would not trigger recognition of income under § 83(a).  Under the terms of § 83(c)(3), it can often be unclear exactly when this restriction lapses, making it difficult to tell precisely when income recognition occurs under § 83.

It is also important to remember that under some circumstances, restrictions on stock transfer and vesting requirements may be waived by a company.  This can cause income recognition under § 83 as to all outstanding shares that were previously subject to the restrictions.  At the same time, however, other, non-contractual restrictions, such as securities law provisions, may effectively preclude the shareholder from selling the stock.

While restrictions on the stock ownership and vesting may cause the recognition of income under § 83 to be delayed, it is possible to elect under I.R.C. § 83(b) to have the income recognized when the options are exercised.  One potential advantage of making such an election is to cause all appreciation after that point to qualify for capital gain treatment and to start the running of the capital gains holding period, which would otherwise be delayed until the restrictions lapse and the stock becomes fully vested.

An election under § 83(b) permits the employee to elect to recognize the difference between the fair market value of the property and the amount paid as compensation income at the time of initial receipt, even if under § 83(a) recognition of income would otherwise be delayed.  See Regs. § 1.83-2.  In situations where the precise timing of the lapse of the restrictions is uncertain, an election under § 83(b) can also serve to remove much of that uncertainty. 

To illustrate the operation of the § 83(b) election, let’s consider an example.  As in the previous example, suppose that the option exercise price is $1.00 per share and that at the time of exercise, the fair market value of the stock is $2.50.  Further suppose that because of the restrictions on the stock, all “unvested” shares are treated as subject to limits on transferability and a substantial risk of forfeiture (i.e., the repurchase right).  Under the Plan’s vesting schedule, 25% of the shares vested after the first year of service. Assume the same vesting schedule and that, at the time of this vesting, the fair market value of the stock was $3.00 per share. 

In the absence of a § 83(b) election, there would be no income recognition at the time of the exercise of the options (because of the restrictions), but when the shares vested, there would be income recognition based upon the difference between the value of the stock (at the time of vesting) -- $3.00 a share -- and the exercise price -- $1.00 a share.  This means that $2.00 a share would be ordinary, compensation income.  Additional appreciation after that point could qualify for capital gain treatment if the stock were retained for the requisite holding period, measured from that point onward.

On the other hand, if a § 83(b) election were made at the time of exercise, then there would be ordinary income recognition based upon the difference between the value of the stock at that time ($2.50 a share) and the exercise price ($1.00 a share), which results in $1.50 a share of ordinary, compensation income.  Suppose then that this stock were later sold for $4.00 a share, the additional $2.50 a share of appreciation would be capital gain, assuming that the requisite holding period requirements were satisfied, measured from the exercise of the option.

A § 83(b) election generally cannot be revoked.  This means that if a § 83(b) election is made and the property subsequently declines in value, the effect of the election will have been to accelerate unnecessarily the recognition of ordinary income.

Incentive Stock Options

ISO plans have two potentially important advantages to employees, in comparison to non-statutory stock options.  First, under § 421, as a general rule, the exercise of the ISO option does not trigger any recognition of income or gain, even if the stock is unrestricted.  Second, if the stock is held until at least one year after the date of exercise (or two years from the date the option is granted, whichever is later), all of the gain on the sale of the stock, when recognized for income tax purposes, will be capital gain, rather than ordinary income.  If the ISO stock is disposed of prior to the expiration of that holding period, then the income is ordinary income.  The basic requirements for an ISO plan are set out in I.R.C. § 422.  An ISO Plan may contain provisions and limitations in addition to the requirements of § 422 so long as they are consistent with the Code requirements.

Thus, there are two significant differences between ISO's and non-statutory options.  First, under the ISO rules, exercise of the option is not a taxable event without regard to the requirements of § 83, at least for regular income tax purposes, but this benefit is somewhat mitigated by the AMT rules, discussed below. By contrast, under § 83, exercise of the option will be a taxable event, unless the stock acquired is not transferable and subject to a substantial risk of forfeiture.  Second, if the ISO holding period requirements are met, all gain will qualify for capital gain treatment. Second, all of the gain with respect to an ISO can be capital gain, if the ISO holding period requirements are met.

While the exercise of an ISO does not cause any taxable event under the regular tax system, it does have consequences under the Alternative Minimum Tax (AMT) system. Under I.R.C. § 56(b)(3), the favorable tax treatment afforded by § 421 and § 422 “shall not apply to the transfer of stock acquired pursuant to the exercise of an incentive stock option,” for AMT purposes. Thus, the tax treatment, for AMT purposes, is governed largely by the rules of § 83, as discussed above. Under § 83, the difference between the fair market value of the stock and the option exercise price will be treated as taxable income when the employee’s rights to the stock become fully vested and no longer subject to a risk of forfeiture.  This “spread” is treated as an AMT adjustment. 

The effect of this AMT adjustment is to cause the taxpayer to recognize AMT taxable income on the exercise of the option, when the stock acquired is substantially unrestricted or not subject to a substantial risk of forfeiture.  In this instance, as noted above, to the extent that under the § 83 rules the stock acquired by the exercise of the option is restricted and subject to a substantial risk of forfeiture, then the AMT adjustment should not occur until the earlier of the time that the stock becomes vested or the restrictions lapse. This is because, for AMT purposes, the option is governed by the rules of § 83.

Regardless of when the AMT adjustment arises, it has several effects.  First, the AMT adjustment -- the spread between the fair market value and the option price -- can become subject to AMT, and AMT tax may have to be paid on that amount, even though the stock might be held for many years or ultimately sold at a loss.  In addition, the basis in the stock, for AMT purposes only, becomes in effect the fair market value as of the date that the AMT adjustment arises.  See I.R.C. § 56(b)(3).  Because of this basis adjustment, when the stock is actually sold, there will be no AMT gain to the extent of the “spread” that was previously subject to AMT tax.

Because the basis in the stock will be different for AMT and for regular tax purposes, the subsequent sale of the stock will generate gain or loss for regular tax purposes, even if it generates no gain for AMT purposes. Since the gain on the sale, determined for purposes of the regular tax, would also include the “spread” that was previously included in the AMT taxable income, there is a risk of double taxation, except for the AMT credit, as determined under I.R.C. § 53.  In theory, the payment of AMT in the year of exercise creates a credit which then reduces the regular tax in the year the stock is actually sold, since in that year, disregarding all other factors, the regular taxable income would be larger than the AMT taxable income, owing to the differences in the stock basis.

This is, at least, the theory, in greatly simplified form.  In practice, however, the extent to which there will be a significant risk of double taxation depends upon the rather complicated calculation and operation of the AMT credit, a full discussion of which is beyond the scope of this article.  For present purposes, a brief overview must suffice.

When a taxpayer is subject to AMT liability in any taxable year, the amount of “adjusted net” AMT paid in that year is available as a credit against his regular tax liability in future years. This credit, however, will not reduce the regular tax below the tentative AMT in any year. Thus, after the credit is created, it may only be used in a subsequent year in which the AMT tax is lower than regular tax.  For example, the credit generated from the AMT paid on the exercise of an ISO could, in theory, be used in the first year in which the AMT tax is lower than the regular tax, irrespective of what caused the difference. 

Of course, the converse is also possible -- namely, in the year in which the stock is sold, other AMT adjustments unrelated to the prior ISO could cause the AMT tax for that year to be the same or larger than the regular tax so that the credit would not be available that year but would carry over indefinitely.  For example, in a year in which the ISO stock is sold, additional ISO exercises or other unrelated AMT adjustments could cause the AMT tax to be greater than regular tax and thus preclude use of the earlier year’s AMT credit.  In reality, it sometimes requires very careful planning in order to be able to take advantage of the AMT credit.  In addition, Congress has been considering a number of different proposals to provide further relief from the AMT, but the prospects for any change in the AMT are uncertain, at best.

In situations such as BigDeal’s, where the stock acquired under the option is not transferable and subject to a substantial risk of forfeiture -- i.e., restrictions that under § 83 would cause recognition of income to be delayed until the restrictions lapse, the advantages of ISO treatment are more limited than in situations where the stock acquired is not subject to a substantial risk of forfeiture.  If because of the restrictions, income recognition on non-statutory option stock is delayed under § 83, then the first difference between ISO and non-statutory options -- lack of income recognition on exercise of the ISO -- may be much less significant. Under such circumstances, the most important benefit of the ISO option is that all gain will be capital gain, if the requisite holding periods are met, but AMT considerations may reduce the value of that benefit. The actual tax savings that might result from ISO treatment, under the such circumstances, can be difficult to predict, in part because they depend upon unknown and unpredictable variables relating to the market value of the stock, an individual's tax situation, and other AMT adjustment events that affect the individual.

Conclusion

While the rules for the two different types of stock options differ, both ISO's and non-qualified options afford employees the opportunity to convert what would otherwise be ordinary, compensation income into capital gain.  Given the current capital gain rates, that advantage can be significant.  Taking full advantage of this benefit, however, can require careful planning at the time of both the exercise and the subsequent sale of the stock.  Careful AMT planning is essential.