Compensating employees with nonemployer stock options.

A flexible compensation alternative

Plans that provide nonqualified stock options for executives and certain other employees--those giving an individual the right to buy a set number shares of an employer's stock (generally after a vesting period) at a specified price for a period of time--are a popular form of compensation in the corporate world. The plans are popular with employers because they enable companies to offer financial incentives to employees without expending any cash. Shareholders like option programs because they believe such programs more closely align the employees' interests with the company's. The employees like them as well because they can control (to a degree) when they benefit from appreciations in the stock value without investing any funds.

However, traditional option programs are not very effective if an employee already holds a lot of options or company stock, the stock appreciates slowly (or not at all) or there are insufficient shams on which to grant options.

NONEMPLOYER STOCK OPTION PLANS

Given the current job market, employers may have to come up with other ways to entice key employees. One alternative is a nonemployer stock option plan in which companies grant employees options to buy stock in other companies. As with regular option plans, the employer has the flexibility to set the terms of the option and any vesting requirements. Similarly, the company may offer the options at a discount (although there is no requirement that this be done). And the employer can maximize the incentive value of these options by using stocks related to the company's business interests (such as the stock of clients).

Employee treatment. For employees, the treatment of nonemployer plans is the same as that for traditional nonqualified stock option plans. When the employer grants an option without a readily ascertainable fair market value (FMV), there are no immediate tax consequences; the employee has no taxable compensation until he or she exercises the option. When the employee does so (that is, sells or otherwise disposes of the option), he or she must recognize ordinary income on the difference between the exercise price and the FMV of the stock received. After selling the stock, the employee realizes capital gain or loss, measured by the difference between the sale price and the stock's FMV on the date of exercise.

Employer treatment. While there are few differences for employees between nonemployer plans and traditional nonqualified stock option plans, there are significant cost, accounting and tax differences for an employer.

Nonemployer option plans are more ex pensive for an employer to create and maintain. The employer must purchase or otherwise acquire the stock on which the options are being granted. While this can be done at any time before the employee's exercise of the option, most employers buy the stock when they adopt the program or grant the options rather than wait for the stock to appreciate. If the company waits to buy the stock and its value rises between the time of the grant and the exercise of the option, the company will be forced to pay the higher price.

The accounting treatment for these plans also differs. Because the plans involve nonemployer stock, an employer must recognize a compensation cost over the period of the employee's service. Thus, granting options under nonemployer stock option plans generally results in a charge to the company's earnings.

For a discussion of this and other developments, see the Tax Clinic, edited by Robert Zarzar, in the July 2000 issue of The Tax Adviser.