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Compensating employees with nonemployer stock options.

Many companies routinely include nonqualified stock options (NQSOs) in compensation packages for their executives and, because of the competitive labor market, for certain other employees. An NQSO gives the employee the right to purchase a set number of shares of employer stock, generally after a vesting period, at a specified price for a specified period. The exercise price typically is the stock's fair market value (FMV) on the day the option is granted.

Programs providing stock options in the employer are popular for several reasons. Companies like option programs because they offer a powerful financial incentive to employees without expending cash. Shareholders like option programs because they believe the programs align executive interests with those of the company and shareholders. Employees view option programs favorably because they permit them to control the timing of income recognition and benefit from any appreciation in the market value of the underlying stock without an initial investment of funds.

There are situations, however, in which traditional option programs do not meet the objectives of a company, its shareholders or employees. If an employee already holds a significant number of options or a large amount of stock, granting additional options will no longer align the employee's interest with the company's and the shareholders'. In these circumstances, furthering the employee's desire for a diversified portfolio may instill greater employee satisfaction and provide the employer with a more powerful compensatory tool. Similarly, when the employer's stock appreciates slowly, it may lack the appeal necessary to attract and retain highly qualified employees in a competitive labor market. Finally, there may be times when there are insufficient shares available on which to grant options because of shareholder sensitivity to further stock dilution.

In these circumstances, companies may create a nonemployer stock option program (nonemployer SOP) and grant options to selected employees to purchase the stock of other companies. Like a NQSO program, a nonemployer SOP offers the employer considerable flexibility, including the ability to set the terms of the option and any vesting requirements. Similarly, the options may be offered at a discount price (although there is no requirement that discounts be offered). Employers also may maximize the incentive value of options in a nonemployer SOP by choosing stocks related to the company's business interests (such as the stock of clients).

One significant difference between a nonemployer SOP and an NQSO program is the requirement that, in a nonemployer SOP, the employer must purchase or otherwise acquire the stock on which options are being granted. While this acquisition may take place at any time prior to or on the employee's exercise, if highly appreciating stock underlies the options, most employers will purchase the underlying stock when adopting the program or granting the options.

Implications for Employees

Generally, the granting of an option in a nonemployer SOP is a nontaxable event for the employee. Sec. 83, which governs the taxation of property transferred in connection with the performance of services, controls the tax treatment of options. Sec. 83(e)(3) and Regs. Sec. 1.83-3(a)(2) and -7(a) provide that no income recognition occurs on granting an option without a readily ascertainable FMV. Thus, as long as an option has no readily ascertainable FMV when granted, the employee has no taxable compensation until the option is exercised.

When an employee exercises, sells or otherwise disposes of an option, ordinary compensation income is recognized on the spread (i.e., the difference between the option exercise price and the FMV of the stock received in connection with the exercise). This compensation must be reported on the employee's W-2, and is subject to applicable payroll tax withholding. The employee realizes either a capital gain or loss when the stock is subsequently sold, measured by the difference between the stock's sale price and its FMV at the date of exercise. The capital gain or loss is not compensatory in nature.

For the employee, identical cash and tax implications flow from a nonemployer SOP and an NQSO program. In both instances, on exercise the executive must pay the exercise price and recognize ordinary income. Consequently, from the employee's perspective, the only difference between an NQSO program and a nonemployer SOP may be the incentive level achieved by the option grant.

Implications for Employers

There are significant accounting, cost and tax differences for an employer that uses a nonemployer SOP, rather than an NQSO program. Also, an employer may face shareholder dissatisfaction by adding a noncash compensation element not tied to company performance.

An NQSO program enjoys favorable accounting treatment under Accounting Principles Board (APB) Opinion No. 25. Under this method, if the option has no intrinsic value when granted (i.e., the strike price equals the FMV), the company generally does not recognize a compensation cost for the option. APB No. 25 accounting, however, is available only for option grants of employer stock to employees. In contrast, a nonemployer SOP is subject to fair-value-based accounting under Financial Accounting Statement No. 123. Under this method, compensation cost is based on a formula-determined value measured at the grant date, and is recognized over the service period. Accordingly, granting options under a nonemployer SOP will generally result in a charge to earnings.

The charge to earnings and the necessity of purchasing the underlying stock make a nonemployer SOP more expensive to create and maintain. The nonemployer SOP also requires the employer to assume greater cost risk. With early purchase of the underlying stock, there is a risk that the stock price will decline before exercise; with delayed purchase, there is a risk that the stock price will rise between the time of the grant and exercise, resulting in additional cost to the company. These expenses, however, may be offset in some cases by income generated by the stock after purchase and prior to the employee's exercise of the option.

When the employee exercises the option, the employer is entitled to a deduction equal to the amount of income recognized by the employee, provided the reporting requirements are met (Sec. 83(h) and Regs. Sec. 1.83-6). However, unlike an NQSO, this deduction may be offset completely by the cost of acquiring the stock and any gain the employer realizes on the transfer of the underlying stock to the employee on exercise (Regs. Sec. 1.83-6(b)).

The significant cost, tax and accounting differences between a non-employer SOP and an NQSO program require employers, before implementing such a program, to consider carefully the hiring and retention demands of the marketplace and the company's compensation objectives. Nevertheless, in today's competitive employment market, a nonemployer SOP can provide employers with a flexible compensation alternative that may help them attract and retain qualified employees.

Robert Zarzar, CPA
Washington National Tax Services
Washington, DC
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Article Details
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Author:Trainer, Corina
Publication:The Tax Adviser
Geographic Code:1USA
Date:Jul 1, 2000
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