Stock Options

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	Understanding Stock Options Personal Finance Advisor by Deloitte & Touche OnLine October 27, 1997

Even your options have options.

By providing equity in the company, stock options can be an effective means of attracting, retaining, and motivating employees and executives.

What is a Stock Option?: Options are the right to purchase shares of common stock at a stated price during a specific period of time. In most cases, options are granted (issued) with an exercise price equal to the fair market value (FMV) of the stock at the date of grant. If the stock price rises above the exercise price, the option can be used to purchase stock at the lower (exercise) price. The difference between the FMV of the stock at the exercise date and the exercise price is the option’s bargain element.

Many stock options vest (become exercisable) six months to one year after the date of grant; however, there are a variety of vesting programs -- serial vesting (a portion/percentage of the options vest each year), cliff vesting (options vest all at once after a specified number of years), and performance-based vesting (options vest if the company stock price reaches certain levels). Unexercised options expire after a period of time, as prescribed in the stock option plan.

Nonqualified Stock Options: The most popular type of options offered today are Nonqualified Stock Options (NQSOs). Income is not recognized by the recipient when NQSOs are granted (except in rare cases). At the time of exercising NQSOs, the bargain element is considered ordinary income to the recipient of the options. The FMV at the date of exercise is the recipient’s basis in the stock. If the stock price goes up after the options are exercised and the stock is sold, the increase/gain is a capital gain for tax purposes. The holding period for capital gains is measured from the date of exercise (not the date the options were granted).

When NQSOs are exercised, the issuing company must withhold social security taxes, federal income taxes (28% rate), and possibly state taxes on the bargain element. The company records an increase in salary expense for tax purposes (a deductible expense) equal to the bargain element.

Incentive Stock Options: From the recipient’s viewpoint, Incentive Stock Options (ISOs) offer greater tax benefits. Income is not recognized on grant or exercise of an ISO. When the stock is sold, the difference between the sale proceeds and the exercise price is a capital gain. Like stock acquired through NQSOs, the capital gain holding period is measured from the date of exercise. The bargain element in ISOs is an addition to alternative minimum taxable income in the year the option is exercised.

Stock acquired under an ISO must be held for at least one year after the exercise date or two years after the grant date. If ISO stock is sold before the end of the minimum holding period, the recipient has a "disqualifying distribution" -- ordinary income tax rates apply to the bargain element in disqualifying distributions.

The issuing company

is not required to withhold income or social security taxes (even if there is a disqualifying distribution), and
does not receive a tax deduction when ISOs are exercised (except in the case of disqualifying distributions).

ISO treatment is limited to exercisable options of $100,000 (FMV date of grant) per year -- options that become exercisable for more than $100,000 FMV in any year will be considered NQSOs.

Financing the Exercise: If the recipient does not have sufficient funds to cover the exercise price, several alternatives are available.

Sell Stock: Raise funds by selling stock from an existing portfolio (may result in taxable gain or loss on securities sold).
Swap Company Stock: Trade issuing company stock already owned (using current FMV) for the exercise price. Trade is tax-free; however, ISO one- or two-year holding periods must be observed.
Pyramid Options: Exchange stock options (using current FMV of options) for the exercise price.
Broker Assistance: Use an advance from a broker to exercise options. Broker immediately sells enough shares to cover the exercise price (i.e., the advance).
Margin Loans: Obtain a margin loan on an existing investment portfolio from your broker. Individual investors can generally borrow up to 50% of the FMV of their portfolio. Interest expense on a margin loan is tax deductible.

Tax Consequences: The following chart summarizes tax consequences for NQSOs and ISOs.

Events	Nonqualified Stock Options	Incentive Stock Options
Grant of Option	No Tax, Unless Option is Publicly Traded and Meets Other Conditions	No Tax
Exercise of Option	Bargain Element Taxed as Ordinary Compensation Income Using Regular Tax Rates	Bargain Element Increases Alternative Minimum Taxable Income
Sale of Stock	Capital Gain or Loss on Sale Price Less Basis (FMV at Exercise Date)	Capital Gain or Loss on the Difference Between the Sale Price and Exercise Price
Disqualifying Distribution	N/A	Bargain Element* Taxed as Ordinary Income Using Regular Tax Rates
*Bargain element is reduced if the sale prices is less than the fair market value of the stock on the exercise date.

Other Considerations: Recipients of stock options should evaluate the impact of a resignation, retirement, or death on options that have not been exercised. Additionally, issuing companies and executives should be aware that the vesting of stock options could trigger "Golden Parachute" tax rules, which could result in a 20% excise tax for the executive and render the bargain element (considered a parachute payment) nondeductible to the company.

These are some thoughts to consider about stock options. Your financial and tax advisor can provide additional information and should be consulted before any action is taken.