Incentive stock option

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Incentive stock options (ISOs), are a type of employee stock option that can be granted only to employees and confer a U.S. tax benefit. ISOs are also sometimes referred to as statutory stock options by the IRS. [1] [2] ISOs have a strike price, which is the price a holder must pay to purchase one share of the stock. ISOs may be issued both by public companies and private companies, with ISOs being common as a form of executive compensation for public companies, and common as a form of equity compensation in private start-up companies. [3]

Contents

The tax benefit is that on exercise, the individual does not pay ordinary income tax nor employment taxes on the difference between the exercise price and the strike price of the shares issued (but may owe a substantial alternative minimum tax if the shares are not sold in the same year, especially if the difference between exercise price and strike price is large, on the order of $50,000 or more). Rather, if the shares are held for 1 year from the date of exercise and 2 years from the date of grant (a "qualifying disposition"), then the profit made above the strike price is taxed entirely as a long-term capital gain, at a maximum rate of 23.8% as opposed to 37%. [1]

History

Tax treatment for the incentive stock option was created by the Revenue Act of 1950. [3] In the following decade, stock option grants became popular as a form of compensation, primarily for executives. The introduction of restricted shares and performance shares in the 1960s and 1970s diminished its popularity, but stock options continued to dominate through the 1960s, 1980s, and 1990s.

In October 2004, section 409(a) of the tax code was added by the American Jobs Creation Act of 2004, which set rules requiring the strike price of the option grant to be at least the fair market value, giving rise to the term 409(a) valuation.

In 2005, law professor Erik Lie published a report into the options backdating involving changing the strike price and date of an option after issue, which led to over 100 SEC and DOJ investigations, resulting in 12 criminal sentences. [4]

As of 2014, stock options including ISOs are no longer the most common form of long-term equity incentive rewards for executives, with about half given as performance shares, a quarter as RSUs, and a quarter as stock options. [3]

Taxation rules

If the shares are sold before the required holding period (a "disqualifying disposition") in the same tax year, then the difference between the price at the time of exercise minus the strike price is taxed as ordinary income, and any additional gain on top of the exercise price is taxed as a short-term capital gain. Short-term capital gains are subject to the same tax brackets as ordinary income but are also subject to the 3.8% net investment income tax. If the incentive stock option is sold above the strike price but below the exercise price in the same tax year, the income is recognized solely as ordinary income. Even if a disqualifying disposition is made, if the shares exercised are not sold in the same tax year, the holder must calculate to see if any alternative minimum tax is owed. [5]

Although ISOs have more favorable tax treatment than NSOs (non-qualified stock options or nonstatutory stock options), they require the holder to take on more risk by holding the stock for a longer period of time if the holder is to receive optimal tax treatment. However, even if the holder disposes of the stock within a year, it is possible that there will still be marginal tax deferral value (as compared to NQOs) if the holding period, though less than a year, straddles the ending of the taxpayer's taxable reporting period. Ordinary income from incentive stock options, unlike wage income or income from NSOs, is also not subject to payroll taxes such as FICA. [6]

Note further that an employer generally does not claim a corporate income tax deduction (which would be in an amount equal to the amount of income recognized by the employee) upon the exercise of its employee's ISO, unless the employee does not meet the holding-period requirements and sells early, making a disqualifying disposition. [7] With NQSOs, on the other hand, the employer is always eligible to claim a deduction upon its employee's exercise of the NQSO.

Elections and considerations

Extended exercise window and conversion to nonqualified stock options

ISOs must be exercised by an employee within 3 months of termination of employment or be forfeited. Since it may be difficult or impossible to sell shares on the secondary market, this would often either force employees to pay a substantial alternative minimum tax liability, or forfeit their earned shares. To solve this issue, some private companies allow the option to convert ISOs to NSOs, which allows the exercise period to be extended to up to 10 years. [8] In March 2015, Pinterest announced that it was allowing employees who had worked with the company for at least two years to convert their ISOs to NSOs and be able to exercise those options for up to 7 years, spurring a wave of companies to follow suit. [9]

83(i) election

The Tax Cuts and Jobs Act of 2017 created the 83(i) election for tax year 2018, which allows an employee of a company satisfying certain requirements to defer taxation upon exercise for up to 5 years. [10] The 83(i) election provision and its requirements is very similar to the Empowering Employees through Stock Ownership Act proposed by senators Mark Warner and Dean Heller in 2016. [11] [12]

Examples of taxation upon exercise and sale

AMT on exercise and both qualifying and disqualifying dispositions

On January 1, 2014, the employee of a private company receives a grant of 1,000 shares at a strike price of $1 vesting monthly over 4 years. Note that the strike price for an employee's ISO grant must be set to the current 409(a) fair market value of the common shares, which is generally lower than that of the preferred valuation of shares owned by venture capitalists that is quoted in news. At this point, the company may contain 9 million shares at a preferred price of $3, valuing the company as a whole at $27 million. [13] [14] At this point, the company can choose to offer the option of early exercise: where an employee can purchase the entire grant before vesting, and perform an 83(b)election and notify the IRS within 30 days with form 83(b). If the employee performs an early exercise and does not fully vest the shares, the exercise price for the unvested shares is returned. In this example, the employee does not early exercise. On January 1, 2018, the company raises another round of funding as the company grows, issuing an additional 1 million shares at a preferred price of $300. The company performs another 409(a) valuation and values the common shares at $200 each. The valuation of the company as a whole is now $3 billion, making it a unicorn.

On February 1, 2018, the employee elects to exercise, or purchase, these vested shares. The employee has fully vested the shares, and must pay a price of $1 per share to purchase these ISOs. The employee pays $1,000 to exercise these shares. The current difference between the common share price, $200, and the strike price, $1, creates a bargain element of $199 per share or a total bargain element of $199,000. If not sold by the end of this year, this $199,000 bargain element along with the employee's ordinary income is taxable under AMT at a maximum rate of 28%, which is then imposed if it is higher than the ordinary tax.

On May 1, 2018, the company raises additional capital in an initial public offering, where the shares are traded on the New York Stock Exchange at $400 per share.

On December 1, 2018, the employee sells 500 of the 1,000 shares at a price of $350 per share. These shares are now a disqualifying disposition because they were sold before a 1 year holding period. This sale generates ordinary income of $175,000.

On December 31, 2018, the remaining 500 exercised but not sold shares creates a bargain element of ($200-1)*500=$99,500 that may be taxed under the alternative minimum tax. For tax year 2018, a single taxpayer earning $100,000 with no special adjustments may incur about $40,000 of AMT preference items such as the bargain element of incentive stock option exercise and hold without paying AMT, due to the AMT exemption. [15]

On February 1, 2019, the employee sells the remaining 500 shares at $300 per share. The employee now owes long term capital gains tax on 500*($300-1)=$149,500. If the taxpayer paid AMT in 2018, the taxpayer is may be entitled to recoup any AMT credit generated in tax year 2019.

Requirements for classification as ISO

Additionally, there are several other restrictions which have to be met (by the employer or employee) in order to qualify the compensatory stock option as an ISO. For a stock option to qualify as ISO and thus receive special tax treatment under Section 421(a) of the Internal Revenue Code (the "Code"), it must meet the requirements of Section 422 of the Code when granted and at all times beginning from the grant until its exercise. The requirements include:

See also

Related Research Articles

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Preferred stock is a component of share capital that may have any combination of features not possessed by common stock, including properties of both an equity and a debt instrument, and is generally considered a hybrid instrument. Preferred stocks are senior to common stock but subordinate to bonds in terms of claim and may have priority over common stock in the payment of dividends and upon liquidation. Terms of the preferred stock are described in the issuing company's articles of association or articles of incorporation.

<span class="mw-page-title-main">Employee stock option</span> Complex call option on the common stock of a company, granted by the company to an employee

Employee stock options (ESO) is a label that refers to compensation contracts between an employer and an employee that carries some characteristics of financial options.

In law, vesting is the point in time when the rights and interests arising from legal ownership of a property are acquired by some person. Vesting creates an immediately secured right of present or future deployment. One has a vested right to an asset that cannot be taken away by any third party, even though one may not yet possess the asset. When the right, interest, or title to the present or future possession of a legal estate can be transferred to any other party, it is termed a vested interest.

<span class="mw-page-title-main">Employee stock ownership</span> System giving employees stake in a companys ownership

Employee stock ownership, or employee share ownership, is where a company's employees own shares in that company. US employees typically acquire shares through a share option plan. In the UK, Employee Share Purchase Plans are common, wherein deductions are made from an employee's salary to purchase shares over time. In Australia it is common to have all employee plans that provide employees with $1,000 worth of shares on a tax free basis. Such plans may be selective or all-employee plans. Selective plans are typically only made available to senior executives. All-employee plans offer participation to all employees.

Business valuation is a process and a set of procedures used to estimate the economic value of an owner's interest in a business. Here various valuation techniques are used by financial market participants to determine the price they are willing to pay or receive to effect a sale of the business. In addition to estimating the selling price of a business, the same valuation tools are often used by business appraisers to resolve disputes related to estate and gift taxation, divorce litigation, allocate business purchase price among business assets, establish a formula for estimating the value of partners' ownership interest for buy-sell agreements, and many other business and legal purposes such as in shareholders deadlock, divorce litigation and estate contest.

Deferred compensation is an arrangement in which a portion of an employee's income is paid out at a later date after which the income was earned. Examples of deferred compensation include pensions, retirement plans, and employee stock options. The primary benefit of most deferred compensation is the deferral of tax to the date(s) at which the employee receives the income.

Restricted stock, also known as restricted securities, is stock of a company that is not fully transferable until certain conditions (restrictions) have been met. Upon satisfaction of those conditions, the stock is no longer restricted, and becomes transferable to the person holding the award. Restricted stock is often used as a form of employee compensation, in which case it typically becomes transferable ("vests") upon the satisfaction of certain conditions, such as continued employment for a period of time or the achievement of particular product-development milestones, earnings per share goals or other financial targets. Restricted stock is a popular alternative to stock options, particularly for executives, due to favorable accounting rules and income tax treatment.

Stock appreciation rights (SAR) is a method for companies to give their management or employees a bonus if the company performs well financially. Such a method is called a 'plan'. SARs resemble employee stock options in that the holder/employee benefits from an increase in stock price. They differ from options in that the holder/employee does not have to purchase anything to receive the proceeds. They are not required to pay the (options') exercise price, but just receive the amount of the increase in cash or stock.

Non-qualified stock options are stock options which do not qualify for the special treatment accorded to incentive stock options.

In finance, options backdating is the practice of altering the date a stock option was granted, to a usually earlier date at which the underlying stock price was lower. This is a way of repricing options to make them more valuable when the option "strike price" is fixed to the stock price at the date the option was granted. Cases of backdating employee stock options have drawn public and media attention.

Stock option expensing is a method of accounting for the value of share options, distributed as incentives to employees within the profit and loss reporting of a listed business. On the income statement, balance sheet, and cash flow statement the loss from the exercise is accounted for by noting the difference between the market price of the shares and the cash received, the exercise price, for issuing those shares through the option.

In the United States, an employee stock purchase plan (ESPP) is a means by which employees of a corporation can purchase the corporation's capital stock, or stock in the corporation's parent company, often at a discount. Employees contribute to the plan through payroll deductions, which accumulate between the offering date and the purchase date. On the purchase date, the company uses the accumulated funds to purchase shares in the company on behalf of the participating employees. The amount of the discount depends on the specific plan but can be around 15% lower than the market price. ESPPs can also be subject to a vesting schedule, or length of time before the stock is available to the employees, which is typically one or two years of service.

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<span class="mw-page-title-main">Employee compensation in the United States</span>

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References


  1. 1 2 "Topic No. 427 Stock Options | Internal Revenue Service". www.irs.gov. Retrieved 2019-09-10.
  2. ↑ TITLE 26 - INTERNAL REVENUE CODE, Subtitle A - Income Taxes, CHAPTER 1 - NORMAL TAXES AND SURTAXES, Regulations § 422 Incentive stock options
  3. 1 2 3 "What Has Happened To Stock Options?". corpgov.law.harvard.edu. 2 October 2014. Retrieved 2019-09-10.
  4. ↑ Lattman, Peter (2010-11-11). "Backdating Scandal Ends With a Whimper". New York Times DealBook. Retrieved 2019-09-10.
  5. ↑ Lipman, Francine (2002). "Incentive Stock Options and the Alternative Minimum Tax: The Worst of Times". Scholarly Commons at UNLV Law.
  6. ↑ "ISOs and Employee Payroll Taxes". The National Law Review. Archived from the original on 2019-08-03. Retrieved 2019-09-10.
  7. ↑ Coughlan, Section 174 R&E Deduction Upon Statutory Stock Option Exercise, 58 Tax Law. 435 (2005).
  8. ↑ Kosoff, Maya. "Pinterest just made a deal with employees that could rock the startup world". Business Insider. Retrieved 2019-09-10.
  9. ↑ "Exclusive: Pinterest unpins employee tax bills". Fortune. Retrieved 2019-09-10.
  10. ↑ Internal Revenue Service (2018). "Notice 2018-97: Guidance on the Application of Section 83(i)" (PDF).
  11. ↑ "Warner, Heller, Paulsen, & Crowley Reintroduce Bipartisan Legislation to Encourage Stock Options for Employees of Startups & Privately-Held Firms". Mark R. Warner. Retrieved 2019-09-10.
  12. ↑ "Bills would ease tax burden of private-company stock options - SFChronicle.com". www.sfchronicle.com. 2016-08-18. Retrieved 2019-09-10.
  13. ↑ Cohan, William D. (2017-03-08). "Valuation Shell Game: Silicon Valley's Dirty Secret". The New York Times. ISSN   0362-4331 . Retrieved 2019-09-10.
  14. ↑ Paul, Jeron (2018-08-07). "409A Valuations vs Venture Valuations". Capshare Blog. Retrieved 2019-09-10.
  15. ↑ "Final GOP Tax Plan Summary: Tax Strategies Under TCJA 2017". Nerd's Eye View | Kitces.com. 2017-12-18. Retrieved 2019-09-10.
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