New Topic - Employee Stock Options

Transcription

1 New Topic - Employee Stock Options I. EMPLOYEE STOCK OPTIONS Corporations may grant their employees the option to purchase stock in the corporation. There are two types of employee stock options: non qualified options and qualified options. A. Nonqualified Options If the option does not meet certain conditions described below, it will be treated as a nonqualified option. A nonqualified option is taxed when granted if the option has a readily ascertainable value when granted. Otherwise, the option is taxed when exercised. 1. Definition of Readily Ascertainable Value If the option is traded on an established market, it will have a readily ascertainable value. Otherwise, it will only have a readily ascertainable value if all of the following conditions are met: a. The option is transferable b. The option is exercisable immedately in full when it is granted c. There are no conditions or restrictions that would have a significant effect on the value. d. The fair value of the option privilege is readily ascertainable. 2. Employee Taxation (Readily Ascertainable Value) a. If there is a readily ascertainable value, the employee recognizes ordinary income in that amount in the year granted. If there is a cost to the employee, then the ordinary income is the value of the option minus the cost. b. There is no taxation on the date of exercise. Basis of the stock is the exercise price plus any amount previously taxed on the date of grant. Any future sale of the stock could result in a capital gain or loss. c. Holding period begins with the exercise date. d. If the employee allows the options to lapse (not exercised), there is a capital loss based on the value of the options previously taxed. 3. Employee Taxation (Without Readily Ascertainable Value) a. If there is no readily ascertainable value, then the taxable event is the exercise date, not the grant date. b. On the date of exercise, the employee recognizes ordinary income based on the fair market value of the stock purchased less amounts paid (if any) for the option. Basis of the stock is the actual exercise price plus any ordinary income recognized. Any future sale of the stock could result in a capital gain or loss. c. Holding period begins with the exercise date. d. If the options lapse, there are no tax consequences 4. Employer Taxation Generally, an employer may deduct the value of the stock option as a business expense in the same year that the employee is required to recognize the option as ordinary income (see above).

2 EXAMPLE On July 1, Year 10, Bob was granted a Non Qualified Stock Option to purchase 200 shares of his employer s stock for $12 per share. This option was selling for $4 per share on an established exchange. Bob exercised these options on August 7, Year 11. The stock was selling for $18 per share on the exercise date. On November 1, Year 12, Bob sold all of the shares for $20 per share. Bob must report ordinary income in the amount of $800 ($4 X 200 shares) on the date of the grant in Year 10 because the option has a readily ascertainable market value. Bob s adjusted basis in the stock is $3,200 ($2,400 exercise price + $800 recognized ordinary income). The $2,400 exercise price is 200 shares X $12. Bob has a long-term capital gain in Year 12 in the amount of $800. This is selling price of $4,000 (200 shares X $20) less adjusted basis of $3,200. Bob s employer can take a tax deduction in the amount of $800 in Year 10, the amount of ordinary income recognized by Bob. B. Qualified Options There are 2 types of qualified stock options, Incentive Stock Options (ISO) and Employee Stock Purchase Plans (ESPP). 1. ISO An ISO is usually granted to a key employee and is a right to purchase the stock at a discount. a. Requirements (1) The ISO must be granted under a plan approved by the shareholders that sets out the total number of shares that may be issued and who may receive them. (2) The options must be granted within 10 years of the earlier of the date when the plan was adopted or approved. The options must be exercisable within 10 years of the grant date. (3) The exercise price may not be less than the FMV of the stock at the date of grant. (4) The employee may not own more than 10% of the combined voting power of the corporation, parent, or subsidiary as of the date of grant. (5) Once exercised, the stock must be held at least two years after the grant date and at least one year after the exercise date. (6) The employee must remain an employee of the corporation from the date the option is granted until 3 months (1 year if due to permanent and total disability) before the option is exercised. b. Employee Taxation (1) Generally, there is no taxation of the option as compensation. Basis of the stock is the exercise price plus any amount paid for the option (if any). (2) Generally, any gain or loss on a subsequent sale of the stock is capital. If the holding period requirements, covered above, are not satisfied, any gain is ordinary up to the amount that the stock s FMV on the exercise date exceeded the option price.

3 2. ESPP (3) Generally, if the options lapse, no deduction is available as the option was not taxed in the first place. There might be a loss if any amount was paid for the option itself. (4) An employee, may exercise up to $100,000 of ISOs in a year. Any amount exercised that exceeds this will be treated as a non-qualifying option. (5) The excess of the FMV of the stock on the exercise date less the purchase price is a preference item for Alternative Minimum Tax. c. Employer Taxation Employers, generally, do not receive a tax deduction for ISOs because it is not considered compensation income to the employee. An ESPP may grant options to employees to purchase stock in the corporation. a. Requirements (1) The plan must be written and approved by the shareholders. (2) ESSP cannot grant options to any employee who has more than 5% combined voting power of the corporation, parent, or subsidiary. (3) Generally the plan must include all full time employees other than highly compensated employees and those with less than two years employment. (4) Option exercise price must be less than the lesser of 85% of the FMV of the stock when granted or exercised. (5) Option cannot be exercised more than 27 months after the grant date. (6) No employee can acquire the right to purchase more than $25,000 of stock per year. (7) Once exercised, the stock must be held at least two years after the grant date and at least one year after the exercise date. (8) The employee must remain an employee of the corporation from the date the option is granted until 3 months before the option is exercised. b. Employee Taxation (1) Generally, there is no taxation of the option as compensation. Basis of the stock is the exercise price plus any amount paid for the option (if any). (2) Generally, any gain or loss on a subsequent sale of the stock is capital. If the holding period requirements, covered above, are not satisfied, any gain is ordinary up to the amount that the stock s FMV on the exercise date exceeded the option price. (3) Generally, if the options lapse, no deduction is available as the option was not taxed in the first place. There might be a loss if any amount was paid for the option itself. (4) If the option price is less than FMV of the stock on the grant date, then ordinary income is recognized as the lesser of the difference of the FMV of the stock when sold and the exercise price, or the difference between the exercise price and the FMV of the stock on the grant date. c. Employer Taxation Employers, generally, do not receive a tax deduction for ESPPs because it is not considered compensation income to the employee.

4 EXAMPLE On July 1, Year 10, Mary was granted an Incentive Stock Option (ISO) to purchase 200 shares of her employer s stock for $120 per share. The FMV of the stock on the date of grant was $120. Mary exercised these options on August 7, Year 11. The stock was selling for $150 per share on the exercise date. On November 1, Year 12, Mary sold all of the shares for $200 per share. Mary does not recognize any ordinary income at the date of grant because this qualified as an ISO. Mary s adjusted basis in the stock is the exercise price of $24,000 (200 shares X $120). Mary has a long-term capital gain in Year 12 in the amount of $16,000. This is selling price of $40,000 (200 shares X $200) less adjusted basis of $24,000. The holding period requirements have been met. Mary also has an AMT preference item in Year 12 of $6,000. FMV of stock on date of exercise was $150, and purchase price was $120. The excess is $30 X 200 shares. Mary s employer receives no deduction for the granting of the option.

5 Stock Option Multiple Choice Questions: 1. Robert Corp. granted an incentive stock option for 200 shares to Beverly, an employee on March 14, Year 12. The option price and FMV on the date of grant was $150. Beverly exercised the option on August 2, Year 14, when the FMV was $180 per share. She sold the stock on September 20, Year 15 for $250 per share. How much gross income did Beverly recognize in Year 12? a. $30,000 b. $150 c. $0 d. $20,000 Choice c is correct. Due to the fact that this is a qualified stock option, there is no recognition of income in the year of grant. Choice a is incorrect. This is the purchase price of the stock upon exercise of 200 shares at $150 per share. It is not income in the year of grant. Choice b is incorrect. This is simply the option price per share on the date of grant. Choice d is incorrect. This is the gain Beverly will recognize upon the sale of the stock. The purchase was 200 shares at $150 per share, or $30,000. The sale was 200 shares at $250 per share, or $50,000. This gain is not recognized until the sale occurs in Year Robert Corp. granted an incentive stock option for 200 shares to Beverly, an employee on March 14, Year 12. The option price and FMV on the date of grant was $150. Beverly exercised the option on August 2, Year 14, when the FMV was $180 per share. She sold the stock on September 20, Year 15 for $250 per share. How much gross income did Beverly recognize in Year 15? a. $30,000 b. $150 c. $0 d. $20,000 Choice d is correct. This is the gain Beverly will recognize upon the sale of the stock. The purchase was 200 shares at $150 per share, or $30,000. The sale was 200 shares at $250 per share, or $50,000. This gain is not recognized until the sale occurs in Year 15. Choice a is incorrect. This is the purchase price of the stock upon exercise of 200 shares at $150 per share. Choice b is incorrect. This is the option price per share on the date of grant. Choice c is incorrect. The realized gain on the sale must be recognized in the year of the sale.

6 3. Wade, Inc. granted a nonqualified stock option for 100 shares at $50 per share to Mary, an employee, on May 1, Year 12. On that date, the option was selling on an established market for $4 per share. Mary exercised the option on August 2, Year 13, when the FMV was $80 per share. She sold the stock on September 2, Year 14 for $100 per share. How much gross income and what type did Mary recognize in Year 12? a. $400 ordinary income b. $400 capital gain c. $5,000 ordinary income d. $5,000 capital gain Choice a is correct. The employee receiving a nonqualified stock option must recognize as ordinary income the value of the option if traded on an established market. Here, that is 100 shares times $4 per share, or $400. Choice b is incorrect. This is the correct amount, but it is ordinary income, not a capital gain. Choices c and d are incorrect per the above explanation. 4. Which of the following statements is not correct? a. Employee Stock Purchase Plans are a type of qualified stock option plan. b. The recipient of an Incentive Stock Option will generally report compensation income in the year the option is received. c. The employer may recognize a deductible expense for a nonqualified stock option in the same year that the employee recognizes ordinary income. d. Once exercised, the stock purchased with an Incentive Stock Option must be held at least two years after the grant date and at least one year after the exercise date. Choice b is correct. Generally there is no recognition of compensation expense with an Incentive Stock Option. Choices a, c, and d are incorrect as these are all true statements.

7 Stock Option TBS #1: Carr, Inc. granted certain employee stock options in Year 1. In the Table below, please indicate for each of the independent situations if the option is an Incentive Stock Option, Employee Stock Purchase Plan, or Nonqualified option. All options and plans have been properly approved as required. All ownership percentages have similar pro rata voting power. 1. Bob, a 7% shareholder, received options to purchase 100 shares of stock, on February 1, Year 1. On that date, the stock price and option price was $20 per share. Bob exercised the options on August 1, Year 1 and sold them on June 1, Year Bob, a 25% shareholder, received options to purchase 100 shares of stock, on February 1, Year 1. On that date, the stock price and option price was $20 per share. Bob exercised the options on August 1, Year 1 when the stock FMV was $30 per share and sold them on June 1, Year Bob, a 7% shareholder, received options to purchase 100 shares of stock, on February 1, Year 1. On that date, the stock price was $25 per share and the option price was $19 per share. Bob exercised the options on August 1, Year 1 when the stock FMV was $30 per share and sold them on June 1, Year Bob, a 5% shareholder, received options to purchase 100 shares of stock, on February 1, Year 1. On that date, the stock price was $25 per share and the option price was $19 per share. Bob exercised the options on August 1, Year 1 when the stock FMV was $30 per share and sold them on June 1, Year 3.

8 ANSWERS AND EXPLANATIONS 1. Incentive Stock Option (ISO). This option meets all of the requirements of an ISO. Bob is a not more than 10% shareholder. The option price is not less than the FMV of the stock on the date of grant. The stock was held at least two years from the date of grant and at least one year from the exercise date. 2. Nonqualified Option. The option does not meet the requirements of either an ISO or Employee Stock Purchase Plan (ESPP) because Bob is a 25% shareholder. Furthermore, the rules of ESPP are not met because the option price is not less than the lesser of 85% of the stock price when granted or exercised. 3. Nonqualified Option. The option does not meet the requirements of either an ISO or Employee Stock Purchase Plan (ESPP). The option price is less than the FMV on the date of grant, so it is not an ISO. Although the option price is less than the lesser of 85% of the stock price when granted or exercised, the option is not an ESSP because Bob is a more than 5% shareholder. 4. Employee Stock Purchase Plan (ESPP). This option meets all of the requirements on an ESSP. Bob is a not more than 5% shareholder. The option price is less than the lesser of 85% of the stock price when granted or exercised (85% of $25 is $20). The stock was held at least two years from the date of grant and at least one year from the exercise date. It is not an ISO because the option price is less than the FMV of the stock on the date of grant.

9 Stock Option TBS #2: In the Table below, please indicate the amount of income to be recognized in Year 1 and Year 3 by the shareholder in each independent situation. 1. Able, Inc. granted an Incentive Stock Option for 50 shares to Mary an employee on April 10, Year 1. The option price and FMV on the date of grant was $45 per share. Mary exercised the option on September 5, Year 1, when the FMV was $75 per share. She sold the stock on November 20, Year 3 for $95 per share. 2. Able, Inc. granted an Incentive Stock Option for 50 shares to Mary an employee on April 10, Year 1. The option price and FMV on the date of grant was $45 per share. Mary never exercised the option, and it lapsed. 3. Able, Inc. granted a Nonqualified Stock Option for 100 shares to Mary an employee on April 10, Year 1. The option price and FMV on the date of grant was $65 per share. The option had a readily ascertainable value of $3 per share. Mary exercised the option on September 5, Year 1, when the FMV was $85 per share. She sold the stock on November 20, Year 3 for $95 per share. 4. Able, Inc. granted a Nonqualified Stock Option for 100 shares to Mary an employee on April 10, Year 1 The option price and FMV on the date of grant was $65 per share. The option did not have a readily ascertainable value. Mary exercised the option on September 5, Year 1, when the FMV was $85 per share. She sold the stock on November 20, Year 3 for $95 per share. Year 1 Year 3

10 ANSWERS AND EXPLANATIONS 1. $0, $2,500. This is an Incentive Stock Option (ISO). Therefore, no income is recognized at the date of grant. When the stock is sold in Year 3, gain of $50 per share (95 45) is recognized. $50 X 50 shares = $2,500. Note that this gain is capital because the holding period rules of 2 years from grant date and one year from exercise date were met. If they were not met, then the first $30 of gain per share (75 45) is ordinary and the remaining gain of $20 per share (95 75) is capital. In this example, the excess of the FMV on the exercise date less the purchase price $30 ($75 - $45) is an AMT preference item. 2. $0, $0. This is an Incentive Stock Option (ISO). Therefore, no income is recognized at the date of grant. The option was never exercised and it lapsed. No income is recognized in any future year, and no deduction is available to the shareholder. 3. $300, $2,700. This is a Nonqualified Stock Option. Mary will be taxed on the value of the option on the date of grant because there is a readily ascertainable value of the option. The amount is $3 times 100 shares = $300. This is classified as ordinary income. There is no additional income recognized as of the exercise. The basis of the stock is $6,800. This is comprised of the exercise price of $6,500 ($65 X 100 shares) plus the $300 previously taxed. The stock is sold for $9,500 ($95 X 100 shares). This results in a capital gain in the amount of $2,700 (9,500 6,800). 4. $2,000, $1,000. This is a Nonqualified Stock Option. Mary will not be taxed on the date of grant because there is not any readily ascertainable value. She will be taxed as of the exercise date based on the difference between the exercise price of $65 per share and the FMV on the exercise date of $85 per share. The amount is $20 times 100 shares = $2,000. This is classified as ordinary income. The basis of the stock is $8,500. This is comprised of the exercise price of $6,500 ($65 X 100 shares) plus the $2,000 previously taxed. The stock is sold for $9,500 ($95 X 100 shares). This results in a capital gain in the amount of $1,000 (9,500 8,500).