Employee empowerment via nonqualified stock options.

• Author: Hereth, Russell H.

Secs. 421 and 422 set forth the rules for traditional qualified incentive stock options (ISOs). The major tax advantages of ISOs are the nonrecognition of income by the employee when the option is exercised and the "favorable" capital gain treatment when the stock is sold by the employee. These benefits will result only if the employer and the employee conform to all of the requirements of the Code.

Prior to 1987, capital gain treatment for employees was very beneficial; the long-term capital gain deduction resulted in only 40% of the gain being taxed at the employee's marginal tax rate, and it was of benefit to all taxpayers to have long-term capital gain treatment. However, the current capital gain blessing is rather meager.

Because the regular tax rates of many employees today would be as low or lower than the capital gain rate of 28%, the employees' ordinary income and their capital gains are taxed at the same rate. The deferral of taxation, therefore, until such time as employees sell their stock would not provide a

tremendous tax benefit for many employees.

For the employer, the ISO provides no deduction of any kind when the option is granted, exercised or sold the employee. Any benefits to the employer must come from employee loyalty and greater employee productivity.

Another factor to be considered when reviewing the possible use of ISOs is that the employee must make payment for the stock when the option is exercised. After exercise, the employee must not dispose of the stock for one year (two years from grant date). If the stock is disposed of prematurely, the bargain element becomes ordinary income to the employee and the employer gets to take a compensation deduction. (Ironically, this may provide a positive aspect for the issuing employer.)

Also, the difference between the exercise price and the stock's fair market value (FMV), on the date of exercise, is a required adjustment for the individual's alternative minimum tax (AMT). This could create a tax burden for those relatively few employees subject to the AMT.

A stock option that does not meet the ISO requirements of the Internal Revenue Code may be referred to as a nonqualified stock option (NQSO). To some employers the nonqualified terminology may cause some alarm. For many employers, however, it may have more beneficial tax consequences than a qualified stock option and still generate an acceptable incentive plan for their employees. In using an NQSO plan, the employer may...