This chapter provides an overview of employee stock options. Incentive stock options are discussed in the next chapter, so the focus here is on nonstatutory stock options. While the benefits are highlighted, caution is suggested especially when providing options to executives in a position to manipulate stock prices. Tax implications include the point at which options become taxable. The chapter concludes with a brief question and answer section. | A formal, written offer to sell stock at a specified price, within specified time limits granted as additional compensation with expectation stock value will rise gives executives advantages of business ownership Two types of stock options are typically used to compensate executives: incentive stock option plans (ISOs) nonstatutory stock options What is it? Copyright 2009, The National Underwriter Company Desirable because expect stock value will rise, allowing gain on spread between option and market price can defer tax to when stock purchased gives executives ownership in the business What is it? Copyright 2009, The National Underwriter Company Employer willing to share business ownership Employer wants to reward executive performance with compensation that increases in value as the employer stock increases in value When is it Indicated? Copyright 2009, The National Underwriter Company Flexible plan design and few tax or governmental regulatory constraints Little to no out-of-pocket cost for company Employee can defer tax until exercise option or later if combine option with nonqualified deferred compensation arrangement Advantages Copyright 2009, The National Underwriter Company Executive bears market risk on stock option 2. Executive must have source of funds for stock purchase 3. Market price of stock may have little relationship to executive performance 4. Employer tax deduction usually delayed until executive exercises stock option Disadvantages Copyright 2009, The National Underwriter Company Option has no readily ascertainable fair market value at time granted: Executive has no taxable income at date of grant When shares purchased, the ‘bargain element’ is treated as ordinary income and taxed accordingly Tax Implications Copyright 2009, The National Underwriter Company Option has no readily ascertainable fair market value at time granted: Employer’s tax deduction taken when option exercised and is equivalent to employee taxable income from the exercise of the option Executive’s basis in the shares = amount paid for the stock + amount of taxable income reported by the executive when option exercised Tax Implications Copyright 2009, The National Underwriter Company Option has readily ascertainable fair market value Employee Taxed at time of grant Employer received at time of grant Employee has no further taxable compensation income when option later exercised Tax Implications Copyright 2009, The National Underwriter Company Stock options are often used by closely held corporations as a way to reward executives. Stock options are a form of compensation with little to no out-of-pocket costs to the company The company bears investment risk when granting a stock option to an executive. True or False? Copyright 2009, The National Underwriter Company 1. False, see page 321 2. True, see page 321. 3. False, see page 322. Tax laws are the same whether or not company stock has a readily ascertainable fair market value at the time that it is granted. An option has readily ascertainable fair market value if it has a value that can be determined as of time of the grant and the option can be traded on an established market. True or False? Copyright 2009, The National Underwriter Company 4. False, see pages 322-323. 5. True, see page 323. What is the effect of federal securities laws on stock option plans? Discussion Question Copyright 2009, The National Underwriter Company
