Employee Stock Options

As an employer, it is important to retain your top talent in a cost-effective way.  Stock options are one tool in your arsenal to be able to keep your employees happy.  In today's blog, we will discuss both what statutory and non-qualified stock options are, and the tax consequences that your employees will face upon their receipt.

A stock option gives employees the right to purchase a certain number of shares of the employer's stock at an established price. In general, the employer's goal in granting the stock options is to both incentivize the employee to remain with the company and work hard to increase the value of the company's stock.

There are 2 general types of stock options: 1) Statutory Stock Options and 2) Non-Qualified Stock Options.

Statutory Stock Option

A statutory stock option receives preferential treatment under our tax system.  Income is not recognized when the stock option is granted or even when it is exercised.  It is only recognized when the the stock is eventually sold.  Furthermore, unlike other type of compensation, the amount realized from the sale is generally treated as a capital gain or loss.

To qualify as a statutory stock option, the following requirements must be met:

• The individual granted the options must be employed by the company granting the option, or a related company, from the time the option is granted until the 3 months before the option is exercised.  However, in the case of incentive stock options (a specific type of statutory stock option), the individual granted the options must be employed by the company granting the option, or a related company, from the time the option is granted until a year before the option is exercised;
• The stock must be held for at least 2 years from the grant date and for at least 1 year from the exercise date; and
• The option may not be transferable except at death.

If the holding period requirement is not met, a portion of the gain will be treated as ordinary income.

Non-Qualified Stock Options

A non-qualified stock option is simply a stock option that is non-statutory.  Unlike a statutory stock option, it will be treated as compensation and taxed at ordinary income rates.  When it is subject to tax depends upon whether the stock's fair market value can be readily determined.  If it can, then the option is taxed to the employee as compensation at the time it is granted.  If it cannot, the employee will recognize compensation when the option is exercised.  The amount included in compensation is the difference between the amount paid for the stock and the fair market value at the time it becomes substantially vested.

If you are considering offering your employees stock options, or if you are an employee receiving stock options, and you have questions about the tax consequences, please do not hesitate to send me an e-mail.

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