Dec 16, 2009


A stock option is an offer to sell stock at a specified price at some time in the future or over a limited period of time with a specific termination date. Stock options have long been used for executive compensation to accomplish some of the same purposes as compensation with restricted stock. Over the years, Congress has designed special tax incentives to make certain types of stock option plans attractive. The type of tax-favored plan currently in effect is known as an incentive stock option (ISO) plan, which will be discussed separately. In this section, stock options in general-sometimes referred to as nonstatutory or nonqualifed stock options-will be discussed first.

Options to buy stock in the employer company are typically granted to executives as additional compensation at a favorable price, with the hope that the value of the stock will rise and make the option price a considerable bargain for the executive. If the stock price declines, the executive simply declines to exercise the option to buy the stock. This gives the executive a benefit whose potential value is tied to the fate of the company, but with no downside risk. This valuable incentive to the executive appears to cost the company very little, although this is somewhat misleading, as discussed below.

Stock options other than ISOs can be designed in any manner the employer and employee desire. Typically, a stock option runs for a period such as ten years, and is granted at a price equal to the fair market value of the stock on the date that it is granted.

Bill Kate is given an option in Year 1 to purchase up to 1,000 shares of stock at $50 per share, which is the current market price, with the option to be exercised over the next ten years. The plan may provide a waiting period before the option may be exercised, or it may provide that the option can be exercised only in successive installments-i.e., only 20 percent of the option can be exercised during the first two years, 40 percent over the first four years, and so on. The option has no value to Bill at the date of the grant because the option price was the same as the market price. Therefore, as of Year 1, there was no taxable income to Bill. Under the general tax rules in this situation, Bill will not be taxed until shares are actually purchased.

Suppose Bill purchases 400 shares in Year 4 for a total of $20,000. If the fair market value of the shares in Year 4 has risen to $40,000, the executive has $20,000 of ordinary income in Year 4. The company will get a tax deduction of $20,000 in Year 4, the same as the amount of Bill's compensation income, again assuming that Bill's compensation meets the reasonable compensation test for deductible compensation. However, the company gets no further deduction if Bill resells the stock and realizes a capital gain.

Options with an immediate value to the executive are sometimes used in executive compensation.

Suppose that the option had been granted at $40 per share, a bargain over the prevailing market price of $50 at the time of the grant. If the option has a determinable value and the option could be traded on an established market, the value of the option is taxable as ordinary income to Bill at the time of the grant, with a corresponding deduction to the employer. If tax is payable at the grant of theoption, there is no further taxable compensation income when the option is exercised later. This can be an advantageous approach if the stock is expected to appreciate substantially in value, because the taxable compensation income at the time of the grant is relatively small, while the remainder of the gain on the overall deal will be taxed as capital gain only when the stock is sold.

Suppose that Bill is granted an option for 500 shares of company stock at $40 per share in Year 1, the current market price being $50 per share. Bill has $5,000 of ordinary compensation income in Year 1, the year of the grant. In Year 4, Bill exercises the option and buys 400 shares for $16,000. There is no ordinary income tax to Bill at the time of the exercise in Year 4.

The stock option appears to be an almost ideal method of compensating executives, providing a valuable incentive-based compensation arrangement at practically no cost to the company. However, the company's cost is comparable to the cost of cash compensation. While it costs the company almost nothing to grant options and print stock certificates to provide shares when the options are exercised, the executive will exercise the option only when the stock has a substantial market value. If this is the case, the company could itself have sold the stock used in the option arrangement on the open market and received the full proceeds. However, the grant of an option does not result in a charge to the company's income statement, so this form of compensation can be attractive from an accounting point of view.

The tax rules applicable to nonstatutory stock options do not provide any particular tax advantage to the employer company in using stock option plans. Therefore, in designing a stock option plan the company must look for benefits to itself just as in the case of any other kind of executive compensation. Typically, stock option plans would be used where the executive has a strong desire to obtain an interest in the business, or where the executive has a direct impact on the company's profits and, therefore, its stock value.


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