There are two kinds of statutory stock options: incentive stock options (ISOs) and options that are granted under a qualified employee stock purchase plan (ESPP). Like nonqualified stock options, both types of statutory stock options are contractual promises that permit an employee to acquire the employer's stock on a future date under terms established on the grant date. However, because ISOs and ESPPs meet specific IRS requirements, they are not taxed on either the grant date or the exercise date (or purchase date in the case of qualified ESPPs). Instead, employees are taxed when they sell their shares. If the employee completes a qualifying disposition, whereby the employee sells the stock at least two years after the grant date and one year after the date of exercise or purchase (the statutory holding period), the employee will recognize a greater capital gain and less ordinary income on the sale of the stock. If the employee sells the stock before the statutory holding period ends, the sale will be a disqualifying disposition and the employee will recognize more ordinary income, which is taxed at a higher rate. FICA will not be due for either ISOs or ESPP shares.
Incentive stock options - tax implications
In addition to complying with the statutory holding-period requirement, an option must also satisfy the following conditions to qualify as an ISO:
- ISOs may be granted only to employees of the employer or a related corporation. For purposes of the ISO rules, the term “employee” has the same meaning as it does in the withholding tax rules of IRC Section 3401(c). Thus, outside directors and other independent contractors may not be granted ISOs.
- ISOs plans may not last longer than ten years and an option exercise period cannot be longer than 10 years from grant. Options under the plan must be granted within ten years from the date that the plan is adopted or approved by shareholders, whichever is earlier. Although the term of the plan is ten years, all ISOs may have up to 10 years for exercise, so that even an ISO granted in the ninth year of a plan may have a ten-year term (5 years for a 10% shareholder).
- ISOs must have a FMV exercise price. The exercise price cannot be less than 100% of the fair market value of the stock at the grant date (110% in the case of options that are granted to shareholders that hold 10% of the company’s stock). A reasonable, good-faith method may be used to determine the fair market value. If it is determined that the exercise price is less than the fair market value of the stock on the grant date, the option cannot be treated as an ISO and will be considered a deferred compensation arrangement subject to IRC Section 409A.
- ISOs must be exercised within three months of an employee’s termination. If termination results from disability, ISO treatment may continue up to one year following termination. If an employee dies and the ISO is transferred by bequest or inheritance, the option may continue to be treated as an ISO for its full term. An ISO can specify a shorter exercise period if desired.
- Only a limited number of ISOs may be granted. Not more than $100,000 worth of ISOs, valued at the grant date, may become exercisable in any year for an individual employee. Any stock options granted that exceed the $100,000 vesting limit will be treated as nonqualified stock options. This limit applies on an aggregate basis to all ISO plans of the employer, its parent, and subsidiaries awarded to an individual employee. While the assessment is initially made at the time of grant, it should be re-assessed as needed, for example if a change in control accelerates vesting of ISOs.
- The ISO plan must be approved by the company’s shareholders within one year of adoption of the plan. The approved plan must specify the aggregate number of shares that can be issued and the eligible class or classes of employees that may participate in the plan.
- ISOs may only be granted on a corporate employer’s stock. ISOs may only be granted over corporate stock; partnership interests cannot be granted through an ISO.
- ISOs cannot be transferred. The option agreement should specifically state that the ISOs cannot be transferred, other than through a will or by the laws of descent.
An ISO can generally only be exercised by paying the exercise price in cash or tendering previously acquired shares. Other cashless exercise mechanisms, such as a net settlement and certain types of same day sales, will at a minimum, convert the options used to cover the exercise price into nonqualified stock options, and may in fact convert the entire option award into nonqualified stock options. Companies should monitor the exercise mechanics to ensure that ISO status is retained throughout the exercise process.
If an employee sells the shares obtained from the exercise of the option through a qualifying disposition, the individual will pay only long-term capital gain taxes on sale proceeds that exceed the option’s exercise price. Although an employee does not recognize taxable income until the shares are sold or otherwise disposed of, the employee will have to make an adjustment to reflect the alternative minimum tax (AMT) in the year of exercise. The excess of the fair market value of the shares at exercise over the exercise price is included in the calculation of the taxpayer’s AMT as a tax adjustment item. This adjustment is not required if the shares are sold in the same year as the option is exercised.
If an employee fails to meet the statutory holding-period requirements (i.e., if the employee sells the shares within two years after the grant date or one year after the exercise date including via a net share settlement), the ISOs will be deemed as having been disposed of in a disqualifying disposition. In a disqualifying disposition, the exercise of the option will be treated as though the option was a nonqualified stock option. Even though employment taxes will not be due, ordinary income tax will be imposed on the stock’s fair market value on the exercise date less the exercise price.
If the amount realized on the sale exceeds (or is less than) the sum of the amount paid for the shares and the amount of income recognized on the disqualified disposition, the gain (or loss) is determined under the rules of IRC Section 302 or 1001, as applicable.
The employer is not required to withhold income tax on any portion of the ordinary income or capital gain that is triggered upon disposition; however, the employer is required to report the compensation income on the employee’s Form W-2.
Employee stock purchase plans - tax implications
ESPPs allow employees to purchase company stock (usually via a payroll deduction) at a discount that does not exceed 15%. For purposes of federal income tax, this discount does not result in immediate compensation, provided that the statutory holding period requirements and the requirements of IRC Section 423 are met. For a plan to qualify as an ESPP, it must meet the following requirements:
- ESPPs may only be offered to employees of the employer or related corporations.
- ESPP grants must be offered to all employees on an equal basis.
- ESPP shares may be purchased only by an individual who is an employee from the grant date to three months before the purchase date.
- An employee who has voting power that is greater than 5% may not participate in the plan.
- Certain employees may be excluded from participating in an ESPP, including
- Employees who have been employed for less than two years.
- Employees who customarily are employed 20 hours or less per week.
- Employees who customarily are employed no more than five months in a calendar year.
- Highly compensated employees, as defined in IRC Section 414(q).
Because ESPPs must be granted to all employees of US companies to qualify for favorable treatment under IRC Section 423, multinational companies should generally be careful not to exclude those employees who work for overseas branches or representative offices of US companies.
ESPPs must also comply with the following conditions:
- The plan is approved by the shareholders of the company within 12 months before or after the plan is adopted.
- The plan designates the aggregate number of shares that may be issued.
- The awards granted under the ESPP are in the stock of the employer.
- The term during which a participating employee has the option to purchase the employer’s stock cannot exceed 27 months, unless the option price is not less than 85% of the stock’s fair market value at the time that the option is exercised.
Further, an employee cannot accrue a right to purchase more than $25,000 (valued at the grant date) of stock each year under any ESPP of the employer, its parent company, and subsidiary corporations.
If the ESPP designates a maximum number of shares that may be purchased by each employee during the offering, or establishes a fixed formula to determine that number (such as $25,000 divided by the fair market value of the stock on the first day of the offering period), the first day of the offering period is deemed the “option grant date.” Establishing this date is critical to avoiding issues under IRC Section 409A. If no maximum is set, the option grant date for purposes of establishing the minimum exercise price is deemed to be the exercise date.
In the case of a qualifying disposition, if an option has an exercise price that takes advantage of the IRC Section 423 discount feature, the employee must include in ordinary income, at the time that the stock is disposed (assuming that the statutory holding-period requirement is met), the lesser of the following two amounts:
- The amount of the fair market value of the shares at the time of the disposition or the employee’s death that exceeds the exercise price of the option.
- The amount of the stock’s grant-date fair market value that exceeds the option’s exercise price.
Any additional gain upon selling the stock should be treated as a long-term capital gain.
If the stock is sold through a disqualifying disposition, the employee will recognize ordinary income that is equal to the difference between the purchase date fair market value and the purchase price. This amount is considered ordinary compensation income in the year of sale even if no gain is realized on the sale. The difference between the proceeds of the sale and the employee’s basis in the stock will be treated as a capital gain or loss. Ordinary income that the employee recognizes upon a disqualifying disposition of ESPP shares constitutes taxable income and should be reported by the employer on the employee’s Form W-2; however, taxes do not have to be withheld.
Unlike ISOs, ESPPs provide that even in a qualifying disposition some amount of ordinary income will be recognized at the time of sale. However, the amount of ordinary income in a qualifying disposition is generally lower than the amount of ordinary income in a disqualifying disposition.