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BY HOWARD J. KLEIN
PARTNER; MEMBER, TECHNOLOGY GROUP

Many technology companies use equity-based compensation to reward employees. As an incentive compensation program, equity-based compensation provides benefits for both the employee and the employer. However, it seems little time is spent understanding the tax consequences of stock options.

Technology companies may attract employees through compensation packages that include both Incentive Stock Options (ISOs) and Non-qualified Stock Options (NSOs). On the surface it may seem that an "option is an option." For tax purposes, however, the two different types of option plans are treated substantially different.

Basic Tax Treatment of ISOs
With an ISO plan, the employer corporation grants the employee an option to purchase a specified number of shares of employer stock in the future at a specified price. The option price must not be less than the fair market value (FMV) of the stock at the time the option is granted. As the FMV of the stock increases, the employee has the potential to recognize the appreciation.

With an ISO, an employee does not recognize taxable income at the time the option is granted, becomes vested, or upon exercise. Upon exercise, the employee has to include in Alternative Minimum Taxable Income (AMTI), the difference in the value (spread) between the stock's FMV and the option price (strike price). In addition to so-called "regular" income tax on the employee's federal income tax return, the employee must consider the Alternative Minimum Tax (AMT) if this is higher than the regular tax. Since certain tax deductions are not allowed as deductions for AMT purposes and certain types of income are taxed differently, it is quite possible that an employee can be subject to the AMT even if the tax rate is lower than the regular tax rate.

Sale of ISOs
Beyond the AMT treatment, the employee will have a taxable event only on a later sale or disposition of the stock. One of the major benefits of ISOs is that if appropriate holding period requirements are met, this gain is taxed as long-term capital gain, at a tax rate of 20 percent. If the employee fails to satisfy this statutory holding period, there is a disqualifying disposition of the stock. When a disqualifying disposition occurs, ordinary income is recognized by the employee in the year of sale equal to the difference in the ISO exercise price and the ISO stock fair market value at the time of option exercise.

Treatment by Employer
For income tax purposes, the employer is not entitled to an income tax deduction when an ISO is granted or when it is exercised. The employer is not entitled to a deduction when the employee sells the shares acquired on the exercise of an ISO in a disposition after the holding period expires. A qualifying disposition is favorable for the employee because of capital gain treatment, but it provides no tax deduction for the employer. Alternatively, in a disqualifying disposition, the employee is required to report the gain as ordinary taxable income, but the employer becomes entitled to a tax deduction for that same amount in the year in which the disqualifying disposition occurs.

ISO Requirements
Incentive Stock Options must meet all of the following requirements:

• ISOs must be granted under a plan which sets forth the aggregate number of shares that may be issued as option shares.
• The plan must specify the employees or class of employees eligible to receive ISOs.
• The shareholders must approve the plan within 12 months before or after the plan adoption.
• The ISOs must be granted within 10 years from the earlier of the date the plan is adopted or approved.
• The options must be exercised within 10 years of the grant. For 10 percent shareholders the amount of time is reduced to five years.
• The option price must be no less than the FMV of the stock on the date the option is granted.
• The employee cannot own 10 percent or more of the company's voting stock at the time the option is granted. This rule does not apply if the option price is at least 110 percent of the FMV of the shares subject to the option and if the option is exercisable within 5 years from the date of the grant.
• The option is not transferable during the employee's lifetime.
• The value of shares of employer stock that can be exercised for the first time by an employee in any calendar year under an ISO cannot exceed $100,000, based on the FMV of the stock at the date of grant.

Non-qualified Stock Options
NSOs encompass all options that do not meet the special requirements for ISOs. NSOs may be granted to both employees and non-employees in exchange for their services; thus, independent contractors can receive NSOs. The tax treatment for NSOs is relatively straightforward, unlike the rules for ISOs. Options granted in connection with services are not taxable when granted unless they have a readily ascertainable FMV.

When an NSO is exercised and stock is received, the holder of the option is taxed on the difference between the option exercise price and the stock's FMV at the date of exercise. This spread is taxed as ordinary income. If the holder is an employee, the income is included as compensation subject to federal and state withholding tax requirements. IF the employee chooses not to sell the stock anticipating future growth, he must remit to the employer an amount equal to the federal tax withholding and the option exercise price. If the holder is an independent contractor, the amount of ordinary income is generally to be reported on Form 1099. The holder is then responsible for his or her own income taxes. The employer receives a tax deduction in the employer's taxable year in which the employee includes the compensation element of the option exercise in the taxable income.

Section 83(b) Election
There is a good deal of tax planning involved with trying to avoid the ordinary income/compensation element of NSOs at the date of exercise. The employee can elect to include the value of the option in income at the date of grant by making an election that essentially states, "Tax me now." This is filed with the Internal Revenue Center where the employee files his or her federal income tax return and a copy of the election is attached to the tax return covering the year of the grant. The section 83(b) election must be made within 30 days of the grant of the option.

This is typically done when the value of the option is quite low or even zero, with the result that when the option is exercised and the stock is sold, most or all of the appreciation will be taxed as capital gain rather than ordinary income. If the stock is held for more than one year, the capital gain will be a long-term capital gain.