What’s the benefit of receiving stock options? Stock options, in particular, are a commonly used form of executive compensation. A stock option is generally an award under which an employer grants an employee the right to buy employer stock at a certain price within a set period of time. Treasury Regulation Section 1.83-7(b)(3) describes the privilege associated with receiving options to buy stock as “the opportunity to benefit during the option’s exercise period from any increase in the value of the stock without risking any capital.”
What types of stock options are there? Under the Internal Revenue Code, there are two general types of stock options: nonqualified options and statutory options. Statutory options include options provided under an employee stock purchase plan and incentive stock options (“ISOs”). Any other options granted in connection with the performance of services are nonqualified options.
Nonqualified stock options may be granted either to an employee or non-employee service provider; whereas, statutory options may be granted only to employees. Specifically, a stock option granted to an employee does not qualify as a statutory stock option during all relevant times from the time of grant until a certain period following exercise.
Additionally, nonqualified stock options by definition are not subject to the rigid requirements that statutory options are. However, in return for conforming to Internal Revenue Code requirements, statutory options receive favorable tax treatment. The favorable tax treatment generally associated with statutory options is the employee’s ability to exercise the option, receive vested stock and not realize income until the employee sells the stock.
What are the key differences between statutory stock options and nonqualified stock options? Here’s a chart of the different general characteristics of statutory stock options versus nonqualified stock options related to types, eligible recipients, timing of employee income taxation and timing of the employer’s deduction, if any:
| Characteristic | Statutory Stock Option | Nonqualified Stock Option |
| Types? | Incentive Stock Options (ISO) and Employee Stock Purchase Plan. |
Any other option granted in connection with the performance of services. |
| Who may receive? | Only employees may receive. | Employee as well as service providers may receive. |
| Time of income taxation? | Upon employee’s sale of underlying stock (an event generally after exercise). |
Generally upon exercise of the option but dependent upon whether option has a “readily ascertainable fair market value” at grant. The transfer of stock on exercise is subject to Code Section 83. |
| Time of employer deduction? | If employee gets capital gains treatment, employer gets no tax deduction. |
Generally matched to employee’s inclusion in income upon exercise. |
Retaining expreienced counsel to negotiate stock option grants or handle disputes involving stock options. Executives receiving stock options as compensation need to understand the associated parameters, rights and tax consequences. In addition to negotiating upon entry of the employment relationship, the fluctuation of the recent economy has spotlighted executive disputes regarding whether an employer’s failure to grant stock options or vest shares is a violation of underlying agreements, or whether a termination was implemented to avoid vesting.
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