Stock options revisited.

• Author: Walsh, Judy W.

The Revenue Reconciliation Act of 1993 (RRA) introduced several factors that will influence decisions regarding whether stock options are an attractive compensation technique for top executives. In addition, under the new law, employers and employees will need to reevaluate strategies to produce the greatest after-tax benefit for options previously issued, but not yet exercised. As this article will illustrate, these issues require an understanding of the tax treatment of employee stock options and an analysis of how the RRA changes affect them.

Types of Employee Stock Options

There are two basic types of stock options (with many variations on the basic themes): incentive stock options (ISOs) and nonqualffied stock options (NQSOs). Under each alternative, the employer grants an employee, usually an executive, the right to purchase company stock at some time in the future at a specified price. There are three critical dates to be considered in determining the taxabihty of employee stock option transactions: the date (1) the option is granted to the employee (date of grant), (2) the employee exercises the option and purchases the stock (date of exercise) and (3) the employee sells the stock (date of sale).

* ISOs

Under Sec. 422(b), an ISO must meet the following conditions:

* The option must be granted pursuant to a plan approved by the shareholders within 12 months of the date the plan is adopted. The plan must include the aggregate number of shares that may be issued, and define the employees eligible to receive options.

* The option must be granted within 10 years of the date the plan is adopted.

* The option must not be exercisable more than 10 years after it is granted.

* The option must be nontransferable, except by will or intestacy.

* The option price must not be less than the stock's fair market value (FMV) at the date the option is granted.

* The employee must not own, on the date the option is granted, more than 10% of the voting power of the employer or its parent or subsidiary.

* If the employee owns more than 10% of the company's voting stock, the option is still an ISO if the option price is at least 110% of the FMV of the stock at the date of grant and the option is exercisable within five years of the date of grant.(1)

To obtain the tax benefits of an ISO, Sec. 422(a) requires that --stock received on exercise of the ISO must not be disposed of within two years from the date the option was granted, nor within one year after its exercise; and --the holder must be an employee of the corporation, its parent or subsidiary from the date of grant until up to three months before the date of exercise.

An employee may only exercise ISOs up to $100,000 FMV of stock per calendar year.(2) FMV is determined at the date of grant.(3) Excess options are treated as options not qualifying for ISO treatment, or NQSOs.

* NQSOs

Options that are designated as not being ISOs by the grantor, or that do not meet the statutory criteria for ISO treatment, are NQSOs governed by Sec. 83.(4) Thus, an option may be an NQSO because the employer prefers it to be, or because the option's provisions automatically preclude ISO treatment (e.g., the option price is less than FMV at the date of grant, or the option will be exercisable for a period longer than 10 years).

The critical factor in determining the treat ment of NQSOs under Sec. 83 is whether the option has a readily ascertainable FMV...