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The Taxation of Compensator Stock Options

Esther A. Streete

The taxation of compensatory stock options

Stock options are a kind of equity based executive compensation by which an employer grants an employee the right to purchase shares of its stock at a fixed price during a designated period. Stock options provide the employee-recipient with compensation that will likely receive deferred tax treatment and does not cost the employer anything. Although stock options dilute the value of the stock a little, they are less dilutive that other forms of equity based compensation since the employee-recipient pays for the stock on exercise.

The two kinds of stock options are:

  1. "Incentive stock options" ("ISOs"), are specifically provided for in the Internal Revenue Code and are subject to numerous qualification requirements.
  2. "Nonqualified stock options" ("NQSOs") are options that don't meet these requirements. They are also known as non-statutory stock options or NSOs.

Both kinds of options have tax advantages, but they have different tax ramifications.

Option Grant

ISOs are not taxable on option grant.

NSOs are taxable on option grant only if they have a "readily ascertainable" fair market value (FMV) at grant.

IRS rules provide that a readily ascertainable value exists when:

  • The option is actively traded or immediately transferable;
  • The option is fully exercisable; 
  • The option and the option stock are unrestricted; and
  • In the case on a non-actively traded option, the value of the "option privilege" is readily ascertainable.

At the grant of an ISO, pursuant to the deferred compensation rules under IRC §409A, deferred compensation is not included in income to the extent not subject to a "substantial risk of forfeiture".

At the grant of a NSO, deferred compensation is includible in income, unless the exercise price can never be less than the underlying stock's FMV on the date the option is granted and certain other conditions are met.

Option Exercise

When an ISO is exercised, no regular income tax is owed. Tax isn't owed until the stock is sold.
       1. For stock acquired under options exercised after Oct. 22, 2004, any remuneration that arises
           when stock is transferred on the exercise of an ISO is not subject to FICA or FUTA taxation.

       2. When an NSO which was not taxed at grant is exercised, income tax is owed at ordinary
           income rates on the difference between the value of the option stock at that time and the
           price paid for it (plus any price you may have paid for the option, although generally that will
           be zero).

                     a. Such income is compensation income that is subject to payroll taxes and
                         income tax withholding, unless the option stock is nontransferable or
                         subject to a substantial risk of forfeiture. Once those restrictions no
                         longer exist, then the income is subject to payroll taxes and income tax
                     b. Note that if tax is paid on exercise, all gain from that point on would be capital

Sale of Option Stock.

When ISO stock is sold, the shareholder is taxed at favorable long-term capital gain rates on the difference between the price paid for the stock and the amount realized on its sale.

      1. However, the stock is sold within two years of the option grant or within one year of the option
          exercise, compensation income is deemed to exist to the extent of the bargain element at
          exercise. Any subsequent gain is capital gain, which will be taxed at favorable rates if the stock
          is held for more than one year on the sale date.

      2. For stock acquired under options exercised after Oct. 22, 2004, any remuneration that arises
          when stock is transferred on the disposition of the stock is not subject to FICA or FUTA

      3. Additionally, any income resulting from a disqualifying disposition of stock acquired under an
          ISO is not subject to withholding.

When stock acquired by exercise of an NSO is sold, any gain realized receives capital gain treatment if the optionee was subject to tax either at option grant, exercise, or when restrictions on the option stock lapsed. If the optionee was not subject to tax either at option grant, exercise, or when restrictions on the option stock lapsed, any gain would be considered compensation income at the time of the sale.

The tax rules for compensatory stock options are quite complex. Call Esther A. Streete at 301-441-2420 if you have additional questions about your options, or if you would like to do some tax planning for them.