The tax consequences of any compensatory stock option must be evaluated in light of two factors: the timing of the taxable event and the nature of the income that arises. The taxable event can arise at any one (or more) of four points in time, to wit:  (i) the grant of the option, (ii) the exercise of the option, (iii) the sale of the option or the stock acquired pursuant to the exercise of the option; or (iv) the lapse of a significant risk of forfeiture attached to the option or the underlying stock. As discussed below, depending on a number of factors, the income which arises may be classified as either ordinary income or as a capital gain. Also to be considered is the ability of the corporate employer to claim deductions arising from these transactions.

Incentive Stock Options

The Internal Revenue Code of 1986, as amended (hereafter the "Code") provides for a special class of stock options known as Incentive Stock Options ("ISOs"). As long as the ISOs and the related Incentive Stock Option Plan ("ISOP") are drafted so as to conform to the requirements of the Code and the related Treasury Regulations, the employee will not be taxed upon the grant of the option to him or her, nor will the employee be taxed at the time the option is exercised. ⁽¹⁾ Instead, the employee will be taxed at the time he or she ultimately sells the stock acquired pursuant to the exercise of the ISO. At that time, the employee will be taxed on the difference between the selling price and his or her "basis" in the stock (i.e., the option exercise price paid by the employee). The Code provides that such gain will generally be taxed at long-term capital gains rates. The principal advantages of an ISO, therefore, lie in the deferral of the taxable event and the treatment of income as a long-term capital gain.

Due to the fact that an employee receiving an ISO is not treated as receiving direct compensation, the corporation granting the ISO is not entitled to claim a deduction as the result of the grant or exercise of the ISO except in the limited circumstance described below.

As noted above, the Code imposes several qualification requirements on ISOs. The seven key points may be summarized as follows:

1. Two holding period requirements must be met:

(a) after exercising an ISO, the employee may not dispose of the stock for at least two years from the date the option was granted to the employee and

(b) the stock received upon exercise must be held for at least one year following exercise of the option.

If the employee fails to meet either of these holding requirements, any gain that results from the disposition of the stock will be treated as ordinary income to the employee. (If, however, the fair market value of the stock on the date the option is exercised is less than the amount realized on the subsequent sale, the gain which is taxable as ordinary income will be limited to the difference between the fair market value on the exercise date and the basis of the stock.) To the extent that ordinary income arises upon a disqualifying disposition, the corporate employer will receive a corresponding deduction. (This is an exception to the general rule stated above.) Any additional gain is taxed as a capital gain.

2. The employee must remain in the employ of the corporation from the time the option is granted until three months prior to its exercise (or twelve months, in the case of a permanently disabled employee). Thus, a terminating employee must exercise his or her option within three months after leaving the corporation.

3. The option exercise price must not be less than the fair market value of the underlying stock as of the time the option is granted. Further, in the case of any individual holding a 10% or greater interest in the corporation the exercise price must be at least 110% of the fair market value of the underlying stock at such time.

4. The option, by its terms, must be nontransferable other than at death and must be exercisable during the employee's lifetime only by the employee.

5. The option must be granted within ten years from the date the ISOP is adopted or the date the ISOP is approved by the stockholders, whichever is earlier.

6. The option must, by its terms, not be exercisable after ten years from the date of grant. In the case of an individual who holds a 10% or greater interest in the corporation, the option must be exercised within five years from its date of grant.

7. The aggregate fair market value (determined at the time the option is granted) of stock for which ISOs are exercisable for the first time by an employee during any calendar year is limited to $100,000. Thus, while an employee may be granted ISOs for stock in excess of $100,000 in a particular year, only an amount up to $100,000 may be exercised in any one year.

Nonstatutory Stock Options

Due to the fact that nonstatutory stock options need not comply with the seven technical requirements set forth in the previous section, an employer is afforded a much higher degree of flexibility in structuring such options. For example, there are no specific holding period requirements for nonstatutory stock options. Further, non-employees are eligible to receive nonstatutory stock options.

These operational requirements of Code Section 409A which should be satisfied to avoid adverse tax consequences provide that the Discount Option by its terms state that it is automatically exercised upon (1) the date of the recipient's separation from service from the issuer, (2) the date the recipient becomes disabled, (3) the date of the recipient's death, (4) a specified time (or pursuant to a fixed schedule) established at the date of the grant, (5) a change in the ownership or effective control of the issuer or in the ownership of a substantial portion of the assets of the issuer, or (6) the occurrence of an unforeseeable emergency in the life of the recipient. Code Section 409A provides these events of exercise may not be accelerated by acts of the issuer or the recipient. Code Section 409A also imposes certain requirements upon the recipient who wishes to elect to receive a Discount Option. The implementation of the operational requirements of Code Section 409A effectively eliminates the discretion a recipient has previously had with respect to the time of exercise of a Discount Option. Again, Code Section 409A does not apply to ISOs.

Timing of Taxable Event

There are four events that may arise in connection with stock options which can have tax significance:

1. the grant of the option;

2. the exercise of the option;

3. the ultimate disposition of the option or the stock acquired pursuant to the option; and

4. the lapse of a significant risk of forfeiture attached to the option or the underlying stock.

While ISOs are normally taxed only upon the occurrence of the third event, nonstatutory stock options will be first taxed either upon the first, second or fourth event, depending upon whether the option has a "readily ascertainable fair market value" at the time of grant, whether the underlying stock will be subject to a substantial risk of forfeiture when issued, and whether the option is a Discount Option.

If the option does have a "readily ascertainable fair market value" at the time of grant, the employee will be taxed on the difference between the option's exercise price and the fair market value of the underlying stock as of the date of the option is granted, multiplied by the number of optioned shares. If the option does not have a readily ascertainable fair market value as of its grant date, the employee will not be taxed on the date of the grant subject to the possible application of the doctrine of constructive receipt as discussed below.

Provided it is not a Discount Option, if a nonstatutory stock option does not have a readily ascertainable fair market value as of its grant date, then the option is taxed at the time of the option's exercise in an amount equal to the Bargain Element, i.e., the difference between the option's exercise price and the fair market value of the stock at the date of exercise. The Bargain Element is taxed at ordinary income rates (i.e., maximum federal income tax rates of 39.6% vs. 20% for long-term capital gains). Ultimately, upon disposition of the acquired stock the employee will have either a capital gain or a capital loss (long-term or short-term, depending on the length of time the employee held the stock) equal to the difference between the selling price and the employee's basis in the stock (generally, the sum of the option price plus the amount of taxable income the employee reported either upon the grant or exercise of the option, as the case may be).

Obviously, the key question which arises in connection with nonstatutory stock options is whether a particular option will be seen to have a readily ascertainable fair market value at the time it is granted. For these purposes, options are essentially divided into two categories: those that are actively traded on an established market and those that are not. Options granted by closely-held corporations normally will not be treated as having a readily ascertainable fair market value unless: (i) the option is transferable by the optionee, (ii) the option is exercisable immediately in full by the optionee, (iii) the option or the optioned stock is not subject to restrictions that have a significant effect upon the value of such optioned stock, and (iv) the fair market value of the "option privilege" is ascertainable. See Treas. Reg. §1.83-7(b)(2). ⁽²⁾

In light of the test put forth in the above-cited Treasury Regulation, most nonstatutory stock options granted by closely-held corporations will not be taxed to the employee at the time of grant. Rather, the taxable event will be delayed until the exercise or other disposition of the option (unless the option is a Discount Option).

For example, assume that employee A is granted an option to acquire 100 shares of the stock at $10 per share at a time when the shares have a fair market value of $11 per share. If A later exercises the option and acquires the 100 shares at a time when the fair market value of the stock is $15 per share, he or she will be taxed on $500 which is equal to the Bargain Element, i.e. the difference between the fair market value of the stock on the date of exercise ($1,500) and the amount he is required to pay under the option ($1,000). The employee's basis in the stock will be $1,500, i.e. the $1,000 paid plus the $500 of recognized gain. If A then holds the stock for a year and sells it at $22 per share, the employee will have a $700 capital gain. ⁽³⁾

The forgoing tax result is, however, dependent on the fact that the optioned shares received upon exercise of the option will not be subject to a substantial risk of forfeiture. If, for example, the stock option plan was written in such a manner as to require forfeiture of the shares if the employee should terminate employment within a specified time frame ⁽⁴⁾, the exercise of the option and the receipt of the at risk shares would not be a taxable event. In such a case, absent a Code Section 83(b) election, the employee would not be taxed until such time as the risk of forfeiture has passed. In addition, a Discount Option becomes subject to taxation under Code Section 409A at the time risk of forfeiture has passed.

Comparison Between Incentive Stock Options and Nonstatutory Stock Options

The primary tax advantage inherent in the use of ISOs is that the employee will never realize ordinary income if the various requirements of the Code and ISOP are satisfied. Rather, the employee will have only long-term capital gain upon the disposition of the acquired stock. However, ISOs suffer in comparison with nonstatutory stock options when one considers that (l) the exercise of an ISO will give rise to a tax preference item for purposes of the alternative minimum tax, whereas nonstatutory stock options do not give rise to tax preference items, and (2) the employer does not receive a deduction in connection with the use of ISOs unless the holding period requirements are not satisfied. In some circumstances, the value of the deduction which the employer can take in the context of nonstatutory stock options may well be greater than the tax cost to the employee in exercising such an option. One potential tax disadvantage to recipients of Discount Options is the application of Code Section 409A.

Code Section 83(b) Election:

The general rule regarding nonstatutory stock options issued by closely-held corporations is deferral of income until the option is exercised. However, where the optioned shares are issued subject to a substantial risk of forfeiture the taxation to be imposed on the Bargain Element is normally delayed even further, until such time as the risk of forfeiture has lapsed. In contravention of this general rule, Code Section 83(b) provides an optionee with an opportunity to recognize income on the Bargain Element at the time of the option's exercise even where the optioned shares are issued subject to a substantial risk of forfeiture.

Although the acceleration of the recognition of income might appear to be counter intuitive, in some situations, primarily where the optionee is expecting further appreciation in the value of the shares, utilization of the Code Section 83(b) election makes sense. The alternative example set forth below demonstrates one such situation.

Company grants employee a nonstatutory option on 100 shares, with an exercise price of $10 per share, on July 1, 1999. When issued both the option and the underlying shares will be subject to forfeiture should the employee leave the company for any reason within five years from the date the option is granted. On the date of grant, the fair market value of the shares is $10 per share. The value of the shares appreciates and the shares are determined to have a fair market value of $15 per share as of August 1, 2002, the day on which the option is exercised. On July 1, 2004, the day on which the substantial risk of forfeiture lapses, the shares have a fair market value of $17 per share. The employee sells the 100 shares he or she received upon exercising the option for $2,000 on July 1, 2006.

Without a Code Section 83(b) election in place the following tax results would accrue to the employee:

1. At time of grant:  no income.

2. At time of exercise:  no income (due to the existence of a substantial risk of forfeiture).

3. At the time of the lapse of the risk of forfeiture:  $700 ordinary income.

($17 fair market value - $10 exercise price) * 100 shares = $700

4. At time of disposition:  $300 capital gain.

$2,000 amount realized on sale - $1,700 basis ($1,000 purchase price + $700 recognized gain) = $300

In the alternative, where the employee had a Code Section 83(b) election in place, the following tax results would accrue:

1. At time of grant:  no income.

2. At time of exercise:  $500 ordinary income.

($15 fair market value - $10 exercise price) * 100 shares = $500 ordinary income.

3. At the time of the lapse of the risk of forfeiture:  no income.

4. At time of disposition:  $500 capital gain.

$2,000 amount realized - $1,500 basis ($1,000 purchase price + 500 recognized gain) = $500

Please note that the election would not change the total amount of income/gain which would eventually be recognized by the employee, i.e., the total gain is $1,000 under either alternative. The election does, however, impact the timing and characterization of such income/gain recognition. In particular the electing employee would have $500 of ordinary income in 2002 and a $500 capital gain in 2006. The non-electing employee would have $700 of ordinary income in 2004 and a $300 capital gain in 2006. Given the rate preference afforded capital gains as opposed to ordinary income, the use of a Code Section 83(b) election would appear to be warranted in this situation.

The use of the Code Section 83(b) election does, however, have a down side. As of the time of the option's exercise the future value of the received shares is a matter of speculation, not certainty. If the election is made and the fair market value of the shares decreases, any loss on disposition will be characterized as a capital loss. Further, if for some reason an election is made and the shares are later forfeited (e.g., the employee leaves the company shortly after exercising the option), the electing employee's only recourse is to claim a capital loss in an amount equal to the employee's basis in the forfeited property. Returning to the example set forth above, if in 2003 the electing employee forfeited his or her stock, the employee would be limited to claiming a capital loss of $1,500 in such year. In other words, netting out the actual payment of $1,000 made at the time the option was exercised, he or she would have traded $500 in ordinary income in 2002 for a $500 capital loss in 2003. Clearly this is not a favorable tax result.

Finally, it should be noted that where the optioned stock is subject to a substantial risk of forfeiture, dividends received on such stock will be treated as passing first through the employer and then to the optionee. As a result the employer would be eligible for a deduction as to the amount of the dividend paid on the at risk stock. Further absent a Code Section 83(b) election the holding period as to the optioned shares will not start to run until such time as the substantial risk of forfeiture has lapsed.

Please note, Code Section 83 is not applicable to ISOs. Treas. Reg. § 1.83-8(a)(1).

While it is not possible to discuss all variations which might be incorporated in an ISOP or nonstatutory stock option plan, it is our hope that the foregoing discussion will provide useful background information as you consider which type of plan would best suit your needs.

Endnotes:

1. However, the "spread" between the fair market value of the stock and the option exercise price at the time the option is exercised (sometimes referred to herein as the "Bargain Element") will constitute a tax preference item for purposes of the alternative minimum tax. [back]

2. The position of the Internal Revenue Service is that an option privilege has a value which is greater than simply the difference between the exercise price and the fair market value of the underlying property. The Service believes that the value of the option must include the value of the ability to exercise the option at the same price in the future, taking down additional appreciation in the property without additional costs. Since it is usually impossible to compute this value with any degree of accuracy, non-traded options will seldom, if ever, be seen as having a readily ascertainable fair market value. [back]

3. It should be noted that the $500 of ordinary income which employee A incurs in this example is considered to be compensation, which is deductible by the company at the time of A's recognition thereof. Thus, unlike incentive stock options, the use of nonstatutory stock options will at some point give rise to a deduction by the employer. However, to be entitled to the deduction, the employer must withhold on the employee's income (in this example, the $500) just as with other types of compensation. [back]

4. It is clear, under the applicable Treasury Regulations, that an obligation to work for an employer for two years after the issuance of stock or forfeit same does amount to a substantial risk of forfeiture. [back]