What’s a statutory stock option (as opposed to a nonqualified stock option)? Statutory options include options provided under an employee stock purchase plan and incentive stock options (ISOs). They may be granted only to employees. The employer may be the corporation granting the option or a parent or subsidiary thereof and the stock subject to the option may be the stock of the employer corporation, or of its parent or subsidiary.
Different rules govern an ISO vs. options granted pursuant to an employee stock purchase plan. An ISO is an option that provides an employee with the right to purchase employer stock and that meets the requirements of Section 422 of the Internal Revenue Code. An employee stock purchase plan is a plan that grants stock options to purchase employer stock and that meets the requirements of Section 423 of the Code.
What are the differences between an ISO and employee stock purchase plans? Both ISOs and employee stock purchase plans are subject to a laundry list of statutory requirements but the following are key differences between the two:
- ISOs may be granted to classes of employees so that only executives receive them whereas an employee stock purchase plan must cover all employees of the employer;
- Plans that grant ISOs may create rights and obligations for different classes of employees whereas an employee stock purchase plan must provide all employees the same rights and privileges (except that the amount of stock that an employee may purchase under an option may bear a uniform relationship to the total compensation of all employees); and
- ISOs may have an exercise period of 10 years whereas options granted pursuant to an employee stock purchase plan are generally not be exercised more than 5 years after the date of grant (and that’s if certain value requirements are satisfied).
What are the income tax consequences associated with receiving statutory options? Statutory options are not subject to the complex tax scheme of Code Sections 83 and 409A. Instead, the general rule may be simply stated: An employee does not recognize income upon receipt or exercise of a statutory option. That is, putting aside the alternative minimum tax discussed below, there are no income tax consequences to an employee who receives statutory options until the employee disposes of the underlying stock subject to the options. Generally, a disposition of the stock includes a sale, exchange, gift or any transfer of legal title.
At the time of disposition, the employee is taxed on the excess between the fair market value of the stock at disposition over the option price that the employee paid. Whether the includible amount of income is subject to tax at ordinary income rates or capital gain rates will depend on whether the employee satisfied the holding period requirement. An employee’s disposition of stock within either two (2) years after the date the option is granted or one year after the date the stock is transferred to the employee (i.e. the option is exercised) is known as a “disqualifying event.” If the disposition is pursuant to a disqualifying event, the employee does not qualify for capital gains treatment. Instead, the employee includes income realized on the disqualifying event as compensation subject ordinary income tax rates.
Stop, Beware of the AMT. In addition to normal income tax considerations, however, statutory stock options also rear the ugly head of the Alternative Minimum Tax (AMT) since the difference between the grant price and the fair market value on the day of exercise is taxable compensation under the AMT (with certain exception if the stock is sold in the same year). Payroll taxes are of less concern because a specific exemption applies to statutory stock options so that they are exempt from the social security and Medicare taxes.
Due diligence will help you understand the parameters of what happens to the statutory stock options upon certain events. Employees receiving statutory stock options should be diligent in understanding the applicable plan documents including, but not limited to, provisions addressing vesting, the applicable exercise period, unforeseen events such as death and disability, dividends and stock splits, value and terminations.
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