A stock option is a written offer from an employer to sell stock to an employee at a specified price within a specific time period. A stock option can be a valuable form of additional compensation, because it provides employees with the benefits of company ownership along with potential tax benefits. Stock options usually last for a long period of time (e.g., 10 years) and employees are usually not taxed until they decide to exercise the option. There are two types of stock options that you can offer to your employee: incentive stock options (ISO) and non-qualified stock options (NQSO). This discussion will focus on non-qualified stock options.
Non-qualified stock options (NQSO)
Unlike an incentive stock option (ISO), which must meet certain requirements under Internal Revenue Code Section 422 to achieve its tax-favored status, a non-qualified stock option (NQSO) is a stock option that either does not meet statutory requirements or specifically states that it is an NQSO. Although an employee who participates in an NQSO is not entitled to the same tax benefits as an ISO, it can still be an attractive alternative to an ISO, because it does not have to follow the requirements of Internal Revenue Code Section 422. As a result, an NQSO plan is an extremely flexible form of employee compensation.
Taxation of non-qualified stock options
Generally, if an option does not have a readily ascertainable FMV at the time it is granted to the employee, it is not treated as taxable income to the employee at the date of the grant. Instead, the option is treated as taxable income when the employee purchases the option shares. The amount of taxable income is the difference between the FMV of the shares at the date of purchase and the option price (the amount the employee pays for the shares). As for employer, they do not receive a deduction when the option is granted. Instead, the employer receives a deduction in the same year the employee has taxable income as a result of exercising the option. The amount of the deduction is the same as the amount of the employee’s taxable income.
Example: Jeff was given an option in Year 1 to purchase 500 shares of BioTech, Inc. at the current market price of $50 per share. Jeff could exercise the option at any time during the next three years. In Year 2, he purchased 250 shares for $12,500 (250 x $50). The FMV of the shares at the time of purchase was $18,750 (250 x $75), so Jeff has $6,250 ($18,750 – $12,500) in taxable income. In addition, BioTech, Inc. can deduct $6,250 for Year 2. If the option does have a readily ascertainable FMV at the time of the grant, it is taxed at that time, while the employer receives a corresponding tax deduction.
Tip: Generally, an option has a readily ascertainable FMV if the option can be traded on an established market.
IRC Section 409A
IRC Section 409A contains complex rules that govern non-qualified deferred compensation (NQDC) plan deferral elections, distributions, funding, and reporting. If a NQDC plan fails to satisfy Section 409A’s requirements participants may be subject to current income tax, as well as an interest charge and 20 percent penalty tax. Non-qualified stock options plans may be subject to IRC Section 409A.