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Stock Option Plans In a stock option plan, a company grants to individual employees the contractual right, or option, to buy a certain number of the company's shares over a specified time period, paying a price that is specified at the time of the grant. The specified time period (or “term” of the option) is typically 10 years beginning on the date of the grant, and the price is usually equal to the fair market value of the shares at the time of the grant. The concept behind options is that, if the value of the company's stock goes up in the years following the grant, the employee can benefit by buying the stock at the lower price that prevailed at the time of the grant and then sell it for the higher, post-appreciation price. The value of a stock option to an employee is therefore inherently tied to the future performance of the company.
Stock option plans are popular with companies of all sizes, but especially with smaller companies and start-ups because of their flexibility and relatively low cost to create and administer. They provide a valuable form of employee compensation that preserves the company's cash during the early years. It is also a form of compensation that gives employees an opportunity to gain an equity stake in the company and thereby share in the value they work to generate. This helps to align employee interests with those of the primary owners.
Companies can tie option grants to group or individual performance in a variety of ways. As with cash bonuses, companies are free to decide to whom they will grant options and how many options they will give to each individual. In the past, companies usually limited the award of stock options strictly to management personnel, and stock option plans are still used that way in many companies. In recent years many companies began granting stock options further down into the organization, often involving every employee, though more recent changes in accounting rules are again resulting in options going to fewer employees. Options can be a more effective motivator than a cash bonus because, unlike cash, they continue to act as an incentive for employees well after they have been awarded, since their actual value will be determined by the company's future performance.
The Internal Revenue Code contains a set of rules concerning stock option plans. If a plan operates in compliance with those rules, it qualifies as an Incentive Stock Option (ISO) plan, which affords significant tax advantages to the employees who are granted options under the plan. A company is free, however, to operate a stock option plan without complying with the ISO rules. This type of arrangement is known as a Non-qualified Stock Option (NSO) plan.
At the time options are granted to employees, there is no tax consequence for either the employer or the employee, whether the plan is an ISO or an NSO plan. However, the tax treatment that occurs thereafter differs, depending upon whether the option is an ISO or an NSO.
With an NSO, the employee must generally pay tax on the difference between the exercise price and the current stock price (taxed as ordinary income) on the exercise date. The company receives a corresponding deduction. Upon sale of the stock acquired on option, the employee must pay capital gains tax on any further appreciation in the stock price since the exercise date.
With an ISO, the employee does not pay regular income tax upon exercise. (Some employees may, however, incur tax liability upon exercise of an option under the federal alternative minimum tax rules, or AMT.) Instead, the tax liability is incurred when the stock is sold or disposed of by other certain kinds of transfers, such as gifts. If, after exercise, the employee holds the stock until the statutory holding period is satisfied, the total increase in share value from the date of the option grant to the date of sale of the stock is taxed at capital gains rates. (The statutory holding period is two years from the date of the grant and one year from the date of exercise.) If the employee fails to hold the stock for the required holding period, then the increase in share value from the date of the option grant to the date of exercise will be taxed as ordinary income. Any subsequent increase will then be taxed as capital gain. In addition, employees who leave a company must exercise any vested ISOs withinthree months of departure or they will automatically convert to NSOs.
A company that issues an ISO does not receive a deduction for compensation expense unless an employee fails to comply with the statutory holding period required to receive tax-favored treatment. In that case, the corporate tax deduction is equal to the gain at the exercise date, i.e., the difference between the price paid by the employee upon exercise and the actual fair market value on that date. No corporate tax deduction is recognized in connection with any increase in share value that occurs after the employee has exercised the option and purchased the shares.
Because the tax deduction available to companies in connection with NSOs is of little value to an early-stage start up that is not yet reporting profits, ISOs are commonly granted by such companies. If and when such a company becomes profitable and/or goes public, it will typically switch to granting NSOs.
Historically, the award of stock options did not require the sponsoring corporation to book a compensation expense for the value of the option. But all companies, both public and private, must now record the cost of stock options as a current compensation expense on their financial statements. The options must be valued based on a fair value methodology that takes into account the exercise price of the option; the current price of the underlying share; the expected term of the option; the expected volatility of the share price; expected dividends to be paid during the option’s term; and the risk-free interest rates during the option term. Changes in fair value during the option’s vesting period must be remeasured at each subsequent financial reporting date.
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