The '90s Gold Rush
Joe Cobal worked as a computer programmer for several years when a Silicon Valley headhunter approached him. "How'd you like a job with Start-Up (an Internet start-up company)? Start-Up can't pay you a large salary, but you'll receive stock options." Intrigued, Joe quit his job and moved to Silicon Valley and began working for Start-Up on January 1, 1994.

Joe's salary was 70 percent of his former earnings, but he also received the prized perk: For each year (12-month period) he worked, Joe would receive an option to purchase 50,000 shares of Start-Up, at a penny ($.01) per share. Each option would expire 10 years later. The company's current stock value was ten cents ($.10) a share, but was not publicly traded. The options had no other restrictions.

Joe worked for three years and received his stock options on December 31st of each year. On January 2, 1997, Public, a publicly-traded company bought Start-Up, paying $20 a share. Was Joe an instant millionaire? Answer the following questions:

• If Joe exercises his options prudently, upon his sale of Start-Up stock Joe will receive: (a) $50,000; (b) $150,000; (c) $3,000,000?
• The price Joe will pay to exercise his options is: (a) $5,000; (b) $15,000; (c) $1,500?

If you chose (c) for both answers, you understand why, in Silicon Valley and elsewhere, stock options are the '90's equivalent of the California gold rush. Joe could receive as much as $3 million by exercising options at a cost of $1,500, however, his tax consequences must be examined. The balance of this article will discuss how stock options work and how they are taxed.

Stock Options in General
Stock options have been used for many years by investors. A stock option is, basically, the right to buy a fixed number of shares of stock for a set price (the "strike" price) during a specific period of time; i.e., Joe's right to buy 50,000 shares of Start-up common stock at $.01 a share until January 31, 2005.

The difference between the strike price and the Fair Market Value (FMV) of the stock is the "spread." If the spread exceeds the cost of exercising the option, then the option is "in the money." For example: Suppose you pay $2 for the right to purchase a share of stock at $5 a share for 24 months. If during the option period the FMV of the stock climbs above $7 a share, you are in the money.

Stock Options in the Marketplace
In non-employment-related stock option transactions, the person holding the right to purchase is called the "Optionee" and the person owning the shares is called the "Optionor." The Optionor usually sells the stock option for a premium. For instance, assume an Optionor holds 1,000 shares of GM stock, which is trading at $95 a share. The Optionor might agree to sell the 1,000 shares at $100 a share for one year for an option price of $5,000.

The Optionor is betting the price of GM stock will increase $5 per share (the $5,000 option premium is equivalent to a $5/share increase), while the Optionee believes the stock price will exceed $105/share during the option period.

The tax consequences flowing from an option are based on the "option privileges." The privilege is the Optionee's right to benefit from any increase in value of the underlying stock without being subjected to a risk of loss. Conversely, the Optionor's privilege is the right to benefit from a decrease in the underlying stock without risk of loss.

The fair market value of an option has two parts:

• The value of the option privilege, and
• The difference between the stock's value and the strike price.

The value of the option privilege depends on three main factors:

• Whether the stock has an ascertainable value.
• The probability of the stock's value increasing or decreasing.
• Time period for the option.

Employment-Related Stock Options
Because options have value, receipt of an option in an employment context raises income tax issues. Is the option compensation and thus taxable immediately? Does the corporation treat the option as compensation and take an immediate deduction for the "payment" as though it paid wages? For tax purposes, stock options are divided into "statutory" stock options, which meet the Internal Revenue Code provisions 421 through 424, and all others (called "non-statutory" stock options).

Non-Statutory Stock Options
An employee who receives a non-statutory stock option may be taxed at any one of the following times:

• When the option is granted.
• When he exercises the option.
• When he sells or disposes of the option.
• When the restrictions (if any) on the disposition of the stock acquired by the option lapse.

In contrast, employees who receive a statutory stock option are not taxed until they sell or dispose of the stock.

Employees or independent contractors receiving non-statutory stock options in connection with performing services are taxed at the time of receipt, if the option has a readily ascertainable fair market value (IRC Sec. 83). This rule usually applies to publicly traded stock. Otherwise, the employee is generally taxed when the optioned stock is actually purchased [IRC Reg. 1.83-7(a)].

The value of the underlying stock over the option price is included as income when the right to exercise the option becomes "vested" (the Optionee has the right to exercise the option without restrictions). The Optionor takes a deduction for "compensation" paid to the Optionee at the time the Optionee declares the income.

Note: Under IRC Sec. 83(b), the Optionee may elect immediate taxation on the option, rather than wait until any restrictions placed on the option have lapsed. Thus, the lapse of restrictions, which is usually the point in time when the option becomes taxable, is not a taxable event. Therefore, a Sec. 83(b) election ensures that any future appreciation is not compensation and commences the holding period for long-term capital gains treatment on the disposition of the property. Also, the Optionee owns the option and his basis includes the amount paid to exercise the option and the amount taken as income by virtue of the Sec. 83(b) election.

If Joe's stock options were non-statutory and if Start-Up's stock had a readily ascertainable value of $.10 per share, Joe would have received $4,500 in compensation upon his receipt ($5,000 FMV for Start-Up's stock, less the option price of $500 = $4,500). He should consider immediately exercising his option to acquire the actual stock, since any future appreciation in the stock will qualify for long-term capital gains treatment, maximum federal tax of 20 percent, provided the stock is held at least 12 months prior to sale.

If however, Joe exercised his option then sold the stock immediately to Public, he would have ordinary income treatment on the sale and could be taxed as high as 39.6 percent federal. The lesson? Ascertain whether the stock option plan is non-statutory, and if it is, consider exercising the option at the time you must take the gain as income. This decision depends on the cost of exercising the option and whether you anticipate selling your stock 12 months later.

Statutory Options
Statutory options receive favorable tax treatment. There are two types of statutory stock option plans, incentive stock options ("ISOs") and options granted under a company's stock purchase plan. Generally, these options are not taxed until the employee disposes of the option and gains are treated as capital gains. If the option is held for 12 months or more, the Optionee will have long-term capital gains, taxed at a maximum of 20 percent federal.

Incentive Stock Options
The most popular stock option plan involves ISOs. These are granted by a corporation to an individual in connection with employment, provided the IRS code provisions governing ISOs are met. The employee has no tax consequences from receiving or exercising an ISO and the employer receives no deduction.

The option price cannot be less than the FMV of the optioned stock at the time the option of receipt and the option must be exercisable within 10 years from receipt. Also, the employee cannot own more than 10 percent of all classes of stock, by vote or value, of the company, or its parent and subsidiary companies.

The employee receives long-term capital gains, provided he does not sell the stock for at least:

• Two years after the option was granted; and
• One year after exercising the option.

These holding requirements are waived if the employee dies. Also, the FMV of stock subject to an exercisable ISO cannot exceed $100,000 in any one calendar year. Any excess is treated as a non-ISO.

An employee must remain employed by the Optionor from the time the option is granted until three months before exercise. Under this rule, an employee has three months after termination of employment to exercise an ISO. For disabled employees, the post-termination period is extended to 12 months and is waived upon death.

Failure to meet the holding requirements causes the gain to be taxed as ordinary income, determined at the time the option was exercised. The gain is usually the value of the stock on date of exercise less the option price. The company is entitled to a deduction at the time the employee recognizes the income from the premature disposition.

If Joe received an ISO, then he would need to wait until the following dates to receive long-term capital gains treatment:

Date ISO Received	Date of Exercise (on or before)	Date of Stock Sale LTCG Treatment (on or after)
12/31/94 12/31/95 12/31/96	12/31/95 12/31/96 12/31/97	12/31/96 12/31/97 12/31/98

In our example, if Joe sold all his stock to Public on January 2, 1997 for $20/share, he would receive LTCG treatment on 50,000 shares ($1million), and 100,000 shares ($2 million) would be taxed as ordinary income.

Stock Purchase Plans
Under these plans, if the option price is not less than 85 percent of the stock's FMV at grant, then ordinary income is generally limited to the difference between the option price and the FMV of the stock at the time of the grant. For example, suppose Joe received the right to purchase Start-Up's stock, valued at $10/share for $8.50. If he exercised his option and sold the stock for $25/share, then $1.50 a share would be ordinary income and the balance, $15/share, would be capital gains.

As with ISOs, the employee receives this tax result, provided he does not sell the stock for at least:

• Two years after the option was granted; and
• One year after exercising the option.

These holding requirements are waived if the employee dies. Many of the other requirements that apply to ISOs also apply (with minor modifications) to stock purchase plans. Employees cannot own more than 5 percent of all classes of stock, by vote or value, of the company, or its parent and subsidiary companies.

The option price must be at least 85 percent of the stock's FMV at either the time of receipt or exercise. Also, the option must be exercised within 27 months of receipt. This period is extended to five years if the option price is at least 85 percent of the stock's FMV at the time the option is exercised. Also, no employee may receive options for more than $25,000 of stock per year, determined at the time the option is received.

In Part Two of this article, I will examine the effect of the Alternative Minimum Tax on stock options, and discuss tax and estate tax planning.