Stock option planning: Generating value.

• Author: Sarenski, Theodore J.

Annually, millions of Americans are granted stock options by their employer. The majority of recipients are high-net-worth individuals (or soon will be). The positive impact of this wealth-creation event on a client's life can be amplified with the implementation of sound and prudent planning. The tax treatment upon the exercise of options and the subsequent sale of the underlying shares can vary greatly depending on the option type. However, regardless of the type, all stock option planning has a common goal: to maximize the value generated for the option holder.

The meaning of the term "value" may not be the same for all clients. For some of them, value may be defined as maximizing cash from the sale of the stock or minimizing taxes. Other clients may wish to limit their cash outlay upon exercise of the options. Still others may seek to hold a large equity stake in the issuing company. Not only is it important to understand the tax ramifications of these events, but also it is equally important for the CPA, as the trusted adviser, to proactively use this information to develop a long-term plan that assists clients in realizing all potential value in line with their ultimate goals.

There are generally two classifications of stock options: (1) nonqualified stock options (NQSOs) and (2) qualified stock options, which are more commonly known as incentive stock options (ISOs).The principal difference between these two categories is their treatment for income tax purposes.

Nonqualified stock options

NQSOs are the right to purchase shares of stock at a specified exercise price within a certain period. In most cases, a grant of NQSOs is not a taxable event for the recipient. However, in the relatively rare circumstances where an NQSO has a readily ascertainable fair market value (FMV) on the date of grant, such as where the options are actively traded on an established market, they are taxed upon grant, and the recipient has ordinary income equal to the FMV on the date of grant of the option received less the exercise price paid.

Generally, NQSOs that do not have a readily ascertainable FMV at the time of grant are taxed upon exercise. In most cases, they are not exercisable until the underlying stock vests, with vesting occurring pursuant to a plan document approved by the issuing company. If stock is vested at the time NQSOs are exercised, the option holder has ordinary income in the amount of the bargain element in the stock received, which in this case is the stock's FMV at exercise minus the exercise price paid.

However, in some cases, the stock received when NQSOs are exercised is not vested because the stock is subject to a substantial risk of forfeiture. In this situation, if a Sec. 83(b) election is not made (see below for a discussion of the Sec. 83(b) election), the taxable event occurs when the substantial risk of forfeiture lapses and the stock vests. In this case, the taxpayer again has ordinary income in the amount of the bargain element in the stock, which in this case is the stock's FMV on the date the stock vests less the exercise price paid.

A special tax rule applies if at least 80% of the company's U.S.-based employees are granted stock options during the calendar year and certain other conditions are met. In that event, eligible employees can elect to defer the recognition of income from exercising stock options for up to five years (Sec. 83(i); Notice 2018-97). However, for most clients, a five-year deferral of income tax consequences will not be an available choice.

NQSO planning

Most planning strategies associated with NQSOs are mechanically simple. However, this does not mean those strategies cannot yield a substantial benefit. The following are some common courses of action associated with NQSO planning:

Exercise and sell

For risk-averse clients who want to minimize exposure to a concentrated position...