RRA prompts fresh look at ISOs for corporate executives.

• Author: Wilson, Bill (American executive)
• Position: Incentive stock options

Incentive stock option plans (ISOs) for corporate officers and employees are facing renewed scrutiny in corporate board rooms, where serious consideration is being given to shifting away from nonqualified stock option plans (NQOs).

The renewed interest in ISOs is one of the hottest topics in executive compensation. The Revenue Reconciliation Act of 1993 (RRA) substantially increased marginal tax rates for most top executives, directly raising the immediate tax cost of exercising NQOs.

When an executive exercises an NQO, the result is ordinarily taxable compensation to the executive equal to the value of the stock on that day less its exercise price.

Example: Executive E exercises 1,000 NQOs with an exercise price of $1; the stock is worth $3. The $2 per share spread will produce compensation income of $2,000, and E must pay 1994 Federal income taxes of 41.05% or $821. (This example assumes a top Federal income tax rate of 39.6% and a hospital insurance tax rate of 1.45%.) The corporation will also have a $2,000 tax deduction.

If the options instead are ISOs, E incurs no taxable income on exercise, and the company receives no deduction. E would realize long-term capital gains taxed at a rate of only 28% if he sells the stock after the requisite holding period (two years from the date of the grant of the ISO or one year from the date of its exercise).

The ISO exercise is a preference item for the alternative minimum tax (AMT), which may lessen its attractiveness. Ignoring any AMT consequences, assume the stock from an ISO exercise at $1 per share is held the required time and is sold for $3 per share. The long-term capital gain of $2,000 would be taxed at 28% or $560 (as compared to the $821 due for the NQOs at the time of exercise, a year earlier).

The question of whether to issue NQOs or ISOs requires a look at the tax consequences to both the executive and the company. NQOs clearly are more advantageous to a corporation because of the deduction at exercise, and ISOs are generally more advantageous to executives because no income tax is due until the stock is sold.

Which is best?

NQOs are almost always superior to ISOs for a variety of reasons. This analysis has changed somewhat under the new law, however, and ISOs can be the right choice in certain instances.

Nonqualifed stock option plans usually are superior to incentive stock option plans:

1. For 1994, the corporate Federal tax benefit of about 33.55% (35% less 1.45% for the hospital...