Stock options give the owner a right to purchase shares of a corporations's stock at a specified price called the "exercise price."
Stock options are a common form of Executive Compensation; however, their use has declined since the issuance of FAS 123(R), which provides that stock options must be considered an expense for accounting purposes. In addition, 409A has casued stock options that are issued at less than fair market to be subject to penalties.
Statutory and Nonstatutory Options
A type of stock option known as an Incentive Stock Option has special tax advantages.
Valuation of Stock Options
Unless they are actively traded on a public market, most stock options have no ascretainable value (for tax purposes) at grant. Therefore, the recipient incurs no taxes at grant, even if the options are fully vested.
An 83(b) election cannot be made for stock options (unless they are unvested options with an ascertainable value).The holder of vested options can, however, obtain long-term capital gains tax treatment of shares obtained through the exercise of an option if the shares ares held long enough.
At exercise, the owner of the option realizes ordinary income equal to the FMV of the stock less the price of exercising the option. The employer takes a deduction equal to the FMV of the stock.
Stock option compensation is subject to Social Security, Medicare, and FUTA taxes. Employers must report income from stock option exercises on the W-2s of employees and the 1099s of non-employees (such as directors). Employers must obey withholding laws regarding stock option compensation to their employees. (Withholding is not required for non-employees.) Employers sometimes withhold stock to satisfy the withholding requirements.
The shares resulting from the exercise of a stock option are treated as ordinary capital investments. Notably, shares held for one year or longer are subject to very favorable long-term capital gains rates (15% as of 2008).
Mechanics of Exercise
The simplest way to exercise a stock option is for the holder to pay cash.
To avoid the problem of obtaining large amounts of cash, cashless exercises may also be permitted by the company. In these arrangements, a brokerage loans the holder the money to exercise the options. Immediately after the exercise of the options, the brokerage sells some of the stock to pay for the loan.
Under a net exercise, an individual "pays" to exercise his options by forfeiting shares whose fair market value is equal to the entire exercise price of his options package. For example, if an executive has options for 100 shares worth $100 per share at an exercise price of $50 per share, the executive would forfeit 50 shares to pay the exercise price of $5000 (50 shares x $100 per share = $5000). Economically, the result for the executive is identical, but no cash is needed for the transaction.
Net exercise does not present tax or accounting problems, but is not permitted under many plans.
Related Forms of Compensation
A form of compensation similar to a stock option is a Stock Appreciation Right.
- SAB 110 describes a simplified method for valuing stock options in accordance with FAS 123R.