Nonqualified Stock Options (NQSOs)

In general, NQSOs may be taxable upon transfer (i.e., when granted to an employee) if the option itself (and not just the underlying stock) trades on a public market.  See Treas. Reg. Section 1.83-7.  There is an exception to this rule if all of the following are met:

1. The option is transferable by the employee;
2. The option is immediately exercisable in full;
3. The option is not subject to a restriction that would diminish its fair market value; and 
4. The "option privilege" (i.e., in short the fair market value of the option) is readily ascertainable.

This exception is rarely ever satisfied in the context of the grant of NQSOs to an employee, because the NQSOs are rarely ever transferable by the employee.  Employers prefer to limit whom may become a shareholder.  Also, the ability to either exercise may not be exercisable in full, or the option may be restricted (i.e., so as to secure performance or provide motivation to the employee).  Finally, the option privilege is rarely ascertainable with respect to a startup company that has raised money through one or two rounds of financing.  If, however, this exception is met, then the option would be taxable upon transfer and would receive the same treatment as if it were restricted stock (see Part I).

Assuming the NQSOs do not meet the exception above, then the NQSOs do not trigger any tax consequences until the employee exercises the NQSOs.  Unlike restricted stock, NQSOs do not trigger tax consequences as they vest.  The exercise of NQSOs triggers the application of Section 83, at which point the following occur:  (1) the employee includes in income the difference between the fair market value of the option and the strike or exercise price (i.e., the amount paid for the stock upon exercise), and (2) the employer is entitled to a corresponding deduction.  See Treas. Reg. Section 1.83-7(a).

Example #1.  Suppose (i) employer transfers 10 NQSOs to employee on January 1, 2000; (ii) the strike price is $1.00 a share; and (iii) the NQSOs vest ratably over 5 years.  After 5 years have pasted, on January 2, 2005, and employee is fully vested, he decides to exercise the NQSOs when the stock has a fair market value of $50 a share.  There are no tax consequences to employee until he exercises the NQSOs, at which point he must include $490 in income as compensation -- the fair market value of the stock ($50 x 10 shares), minus the strike price ($1 x 10 shares). 

By the time an employee exercises his NQSOs, the fair market value of the stock could increase dramatically, which would in turn dramatically increase his taxes attributable to the exercise of the NQSOs.  Moreover, the amount included in income is treated as compensation and therefore is subject to ordinary income tax rates (the highest rate is currently 39.6 percent, not including the effective state tax rate). 

Incentive Stock Options ("ISOs")

If a stock option grants meets the definition of an ISO, then Section 83 does not apply and the ISO is taxed under a different set of rules set forth under Section 421 and 422.  See Treas. Reg. Section 1.83-8(a)(1).  To qualify as an incentive stock option under Section 421, all of the following requirements must be met:

1. 1. The grantee must be an employee.
2. The exercise price must be equal to the fair market value of the stock as of the day on which the option is granted.  However, if the grantee has more than 10 percent of the voting power of the stock, then the exercise price must be 110 percent of fair market value of the stock.  Fair market value is easily determined if the stock is publicly traded.  However, if not publicly traded, then the employer corporation must make a good faith effort to determine the fair market value of the stock, which depends on the facts and circumstances of the situation.
3. Upon exercise, the employee must receive stock of his employer corporation (or a subsidiary corporation to his employer).
4. The ISO must be issued pursuant to a qualified stock option plan established by the employer corporation, which meets the following requirements:
   i. The plan sets forth the total number of ISOs that may be issued pursuant to the plan.
   ii. The plan is approved by the shareholders of the employer within 12 months (either before or after) that the employer grants an option under the plan.  If options are granted outside of this 24-month period, then those option do not qualify as ISOs.
5. The ISO grant must specifically state that it cannot be transferred by the employee or exercised by anyone other than the grantee.
6. The option must be granted within 10 years from the earlier date that the plan is adopted or approved by the shareholders.
7. The option granted pursuant to a valid ISO plan must be exercised within 10 years from the date that it is granted.  It should be noted that an employee can exercise an ISO up to 3 months after termination of his employment, and such period is extended up to one year in the event of the employee's death (i.e., the employee's estate would exercise the ISO in such an instance).

The benefits to receive ISO treatment can be substantial.  The employee does not recognize income when the ISO is granted and does not recognize income when he exercises the stock.  The tax consequences to an employee depend on when the employee sells the ISO stock.  Generally, when an employee sells stock that he received pursuant to a valid ISO grant (i.e., the option meets the above requirements), all gain will be treated as capital gain -- and therefore be subject to a maximum federal rate of 20 percent as opposed to the maximum ordinary income rate of 39.6 percent -- if the stock is sold after the expiration of later of the following periods (hereinafter referred to as the "Holding Period"):

1. 2 years from the date that the ISO was granted; and
2. 1 year from the date on which the employee exercised the ISO.

The employer is not entitled to a deduction should the employee satisfy the Holding Period requirements.

Generally, if the employee transfers the ISO stock before the expiration of the Holding Period, then he must recognize compensation income for the year of the disposition in an amount equal to the difference between the fair market value of the ISO stock as of the exercise date and the strike price.  Certain transfers will not trigger a default under he holding period such as a transfer upon death or certain non-recognition transactions (see Section 424(c) for the complete list). 

If an employee recognizes compensation income from selling ISO stock before expiration of the Holding Period, the employer is entitled to a corresponding deduction if the employer satisfies the reporting requirements under Section 6041 or 6041A.  See also Prop. Treas. Reg. Section 1.6039-2(a) (lists informational requirements that must be provided to employees).  However, should the employer fail to timely report such income, then the employer is entitled to a corresponding deduction only if it can prove that the employee actually included the amount in income.  See Treas. Reg. Section 1.83-6(a). 

The employer does not have any withholding obligation with respect to the income that the employee recognizes from a disposition of ISO stock before the expiration of the Holding Period.  The compensation income resulting from a disqualifying disposition of ISO stock does not constitute "wages" for the purposes of FICA or FUTA and is therefore not subject to the Medicare or social security taxes. 

If an employer issues an option that meets all of the requirements of an ISO, but the employer does not intend for the option to receive ISO treatment, then the option grant must specifically state that the option does not constitute an ISO.

Finally, a portion of stock exercised pursuant to an ISO grant will be treated as though issued pursuant to a NQSO grant, if the fair market value of the stock capable of being exercised in any given year exceeds $100,000.  The fair market value of the stock is determined on the date of the option grant.  See Section 422(d).  The employer could issue separate stock certificates that clearly indicate which stock is ISO stock and which is not ISO stock; however, the default rule would treat a proportionate amount of each share of stock according to the rules for ISOs and NQSOs. 

Example 2:  assume Employee receives an option to purchase 15,000 of Employers stock when the fair market value of the stock is 10.  The option is issued pursuant to a valid incentive stock option plan and the option grant complies with all of the ISO structural requirements (i.e., the requirements listed in number 1-7 above have been satisfied).  The option is fully exercisable -- e.g., assume there are no vesting restrictions.  Since Employee received an option to purchase up to $150,000 in one given year, which exceeds the $100,000 limitation as described above, the option will be bifurcated at the time that the employee exercises the option.  Upon exercise, two-thirds of each share will receive ISO treatment and the remaining one-third will be treated according to the rules for NQSOs.  Alternatively, the employer could issue stock certificates identifying 10,000 shares as ISO stock and 5,000 shares as non-ISO stock. 

While one might think ISOs to be truly advantageous from a tax perspective, the alternative minimum tax (AMT) rules cast a cloud of gloom over ISOs.  Essentially, ISOs are treated as NQSOs for AMT purposes.  Specifically, the difference between the fair market value and exercise price is included as an adjustment for determining alternative minimum taxable income.  As a result, any significant ISO grants will be subject to the AMT, which would trigger a tax of 26 percent or 28 percent with respect to the ISO exercise.  Thus, an employee with a significant grant of ISOs would prefer to exercise his ISOs before the underlying ISO stock significantly appreciates (i.e., measured from the time of the ISO grant date).