Option options.

Corporations always are looking for better ways to compensate executives and officers they wish to retain. Stock options have grown in popularity, especially since the Omnibus Budget Reconciliation Act of 1993 increased the top marginal tax rates, renewing interest in capital gains (see also "AcSEC Comments on FASB's Stock Option Proposal," page 9). The two most popular types of option plans are incentive stock option (ISO) plans and non-qualified stock option (NQO) plans.

INCENTIVE STOCK OPTIONS

Under an ISO plan, an employee is given the right to purchase stock from a corporation for a specified period of time and at a stated price. Such a plan must specify the total number of shares that may be issued and the employees (or class of employees) eligible to participate. There must be limits on plan duration and the options to be granted. An ISO must be granted within 10 years from either the date the plan is adopted or the date it is approved by the shareholders (whichever is earlier).

Option price. The option price must not be less than the stock's fair market price on the date the option is granted. However, for individuals owning more than 10% of a corporation's stock, the option price must be at least 110% of the stock's fair market value on that date.

Holding period. Stock acquired through the exercise of an ISO cannot be disposed of until at least two years after the option is granted or one year after the stock is transferred to the employee. In addition, for the entire time from the date an ISO is granted until three months before it is exercised, the option holder must be an employee of the company granting the option (or a related company).

EXERCISING ISOs

Only the person to whom an ISO is granted may exercise it during his or her lifetime; not even spouses are eligible. In addition, an option may not be assigned as part of a divorce settlement, and the right to exercise one may not be sold or otherwise used as collateral. An ISO may not be contributed to individual retirement accounts or other retirement plans. However, on an option holder's death the option goes to his or her beneficiary, who in turn may exercise it.

Generally, an option holder must exercise his or her option within 10 years of the date it is granted; if he or she owns more than 10% of the company's stock, the exercise period is 5 years.

For ISOs granted after 1986, no more than $100,000 in options (valued when they are granted) may be exercised for the first time in any one year. If this rule is violated, the first $100,000 in options still qualify as ISOs, but the remaining options are treated as NQOs.

TAX TREATMENT OF ISOs

The key tax feature of an ISO is that there are no regular income tax consequences when it is granted or exercised, although there may be alternative minimum tax (AMT) consequences. The employee does not recognize any taxable income when an ISO is either granted or exercised. On the sale of stock acquired under an ISO, the employee's income is taxed as a capital gain or loss.

Note: If a plan does not meet all the ISO requirements, each option is treated as an NQO. In addition, if an employee triggers a disqualifying disposition--by holding an ISO for less than the requisite holding period or otherwise violating ISO requirements--the option is treated as an NQO.

AMT treatment. For purposes of the AMT, a taxpayer's regular taxable income must be adjusted to include the difference between the ISO's exercise price and the underlying stock's fair market value on the exercise date. Thus, while exercising an ISO has no regular tax effects, a taxpayer may incur some AMT liability, depending on the amounts involved and his or her individual situation.

NONQUALIFIED STOCK OPTIONS

If an option plan does not meet the ISO requirements, either by definition or by effect, it is an NQO plan.

Generally, there are no tax consequences when an NQO is granted. However, when an employee exercises an NQO and purchases the stock, he or she must pay tax on the difference between the option price and the market price, which is treated as ordinary income. Also, if the stock is later sold, the employee is taxed on any gain.

Determining which type of plan is better requires an analysis of many factors. For a discussion of some of these factors, see the Tax Clinic, edited by Glenn Mackles, in the March 1994 issue of The Tax Adviser.

Nicholas Fiore, editor The Tax Adviser

Ed. note: The material discussed provides general information. Before you take any action in this area, the appropriate code sections, regulations, cases and rulings should be examined.