Tax and Non-tax Aspects of Stock Options.

Stock options have become an important part of employee compensation packages. Employers options as an effective means of attracting, retaining, and motivating employees, and employees enjoy the opportunity to participate in the appreciation of their employers' stock price. To maximize the benefits of options, employers and employees need to understand how different types of options are taxed and the methods for funding the exercise.

Basic Terms -- Options are the right to purchase shares of common stock at a stated price during a specific period of time. In most cases, options are granted with an exercise price equal to the fair market value (FMV) of the stock at the date of grant. If the stock price rises above the exercise price, the option can be used to purchase stock at the lower (exercise) price. The difference between the FMV of the stock at the exercise date and the exercise price is the option's bargain element. Most employee stock options vest (become exercisable) at a date after the date of grant. Unexercised options expire after a period of time, as prescribed in the stock option plan.

Types of Stock Options--There are two types of stock options commonly used in employee compensation-nonqualified stock options (NQSOs) and incentive stock options (ISOs). The tax treatment differs substantially for each type.

* Nonqualified Stock Options -- NQSOs are the most popular type of options offered today. The recipient employee does not pay income tax when the NQSOs are granted (except in rare cases). When the options are exercised, the bargain element is taxed as ordinary income to the employee (this is true even if the employee has given away the NQSOs, for example, to a trust for his/her children). The FMV at the date of exercise is the recipient's basis in the stock. If the stock price goes up after the options are exercised and the stock is later sold, this increase is a capital gain. The holding period for a capital gain is measured from the date of exercise (not the date the options were granted).

When NQSOs are exercised, the issuing company must withhold social security taxes, federal income taxes, and possibly state taxes on the bargain element. The company records an increase in salary expense for tax purposes (a deductible expense) equal to the bargain element.

* Incentive Stock Options -- From the recipient's viewpoint, ISOs may offer greater income tax benefits (although, unlike NQSOs, ISOs cannot be gifted). The employee does not recognize income on the grant of ISOs (as with NQSOs) and he/she does not recognize income on the exercise of ISOs (unlike NQSOs)-the bargain element in an ISO is an addition to alternative minimum taxable income in the year the option is exercised. When the stock is sold, the difference between the sale price and the exercise price is a capital gain, provided certain holding period requirements are met. Stock acquired under an ISO must be held for at least one year after the exercise date, or two years after the grant date. IfISO stock is sold before the end of the minimum holding period, the recipient has a disqualifying distribution-ordinary income tax rates apply to the bargain element in disqualifying distributions. Like stock acquired through NQSOs, the capital gain holding period is measured from the date of exercise.

There is some controversy as to whether the issuing company is required to withhold social security taxes, federal income taxes, and state income taxes (if applicable) upon exercise of an ISO or a disqualifying distribution. ISO treatment is limited to exercisable options of $100,000 (FMV on date of grant) per year-options that become exercisable for more than $100,000 FMV in any year will be considered NQSOs.

Financing the Exercise -- When options are exercised, the employee (or other holder) must pay the employer the exercise price. If the employee does not have sufficient funds to cover the exercise price, several alternatives are available:

* Sell Stock -- Raise funds by selling stock from an existing portfolio (may result in taxable gain or loss on securities sold).

* Swap Company Stock -- Exchange issuing company stock already owned (using current FMV) for the exercise price.

* Cashless Exercise -- Pay exercise price on options by simultaneously exercising options, selling a portion of the shares issued on exercise, and paying the exercise price with the proceeds. Additional shares are sold to satisfy tax withholdings.

* Stock Pyramiding--Pay cash to exercise a few options, then redeem the option shares in order to exercise more options, repeating this process until all the options are exercised.

* Margin Loans - obtain a margin loan on an existing investment portfolio from your broker. Individual investors can generally borrow up to 50 percent of the FMV of their portfolio, and interest expense on a margin loan is tax deductible.

From "The Review: News and Analysis of Key Business Issues" by Deloitte & Touche / October 11, 1999.