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Employee empowerment via nonqualified stock options.

Secs. 421 and 422 set forth the rules for traditional qualified incentive stock options (ISOs). The major tax advantages of ISOs are the nonrecognition of income by the employee when the option is exercised and the "favorable" capital gain treatment when the stock is sold by the employee. These benefits will result only if the employer and the employee conform to all of the requirements of the Code.

Prior to 1987, capital gain treatment for employees was very beneficial; the long-term capital gain deduction resulted in only 40% of the gain being taxed at the employee's marginal tax rate, and it was of benefit to all taxpayers to have long-term capital gain treatment. However, the current capital gain blessing is rather meager.

Because the regular tax rates of many employees today would be as low or lower than the capital gain rate of 28%, the employees' ordinary income and their capital gains are taxed at the same rate. The deferral of taxation, therefore, until such time as employees sell their stock would not provide a

tremendous tax benefit for many employees.

For the employer, the ISO provides no deduction of any kind when the option is granted, exercised or sold the employee. Any benefits to the employer must come from employee loyalty and greater employee productivity.

Another factor to be considered when reviewing the possible use of ISOs is that the employee must make payment for the stock when the option is exercised. After exercise, the employee must not dispose of the stock for one year (two years from grant date). If the stock is disposed of prematurely, the bargain element becomes ordinary income to the employee and the employer gets to take a compensation deduction. (Ironically, this may provide a positive aspect for the issuing employer.)

Also, the difference between the exercise price and the stock's fair market value (FMV), on the date of exercise, is a required adjustment for the individual's alternative minimum tax (AMT). This could create a tax burden for those relatively few employees subject to the AMT.

A stock option that does not meet the ISO requirements of the Internal Revenue Code may be referred to as a nonqualified stock option (NQSO). To some employers the nonqualified terminology may cause some alarm. For many employers, however, it may have more beneficial tax consequences than a qualified stock option and still generate an acceptable incentive plan for their employees. In using an NQSO plan, the employer may provide more flexible terms than an ISO plan since the qualification requirements of the Code are avoided. In avoiding the qualified ISO requirements, the employer can grant the option at any price, allow for much more flexibility in setting up the duration period, and avoid the statutory dollar amount limitation. In addition, the excess of the option's FMV over the price paid by the employee is not subject to the AMT. Since NQSO plans are nonstatutory, they are not subject to Secs. 421 and 422. However, there may be legal requirements resulting from state law and Federal securities law.

While a qualified ISO does not provide for any deduction by the employer, the NQSO does. This certainly is a positive factor for an employer and augments the flexibility provided by the nonqualified plan. The deduction by the employer for compensation is equal to the amount of income recognized by the recipient and in the same period when the income is recognized. Sec. 83(h) sets forth the rules for this deduction.

The employee's tax treatment of an NQSO hinges on whether the stock option has a readily ascertainable FMV on the date of grant (see Regs. Sec. 1.83-7). In most cases the exercise price is greater than the FMV on the grant date and readily ascertainable FMV is not available. However, when there is active trading of the option on an established market, income will be recognized, in most instances by the recipient when the option is exercised. At that time the income recognized is the excess of FMV over the stock's exercise price. This creates ordinary income to the employee, and when the employee sells his shares, a capital gain (or loss) will be recognized.

The NQSO plan, therefore, may be better suited for an employer than the qualified ISO plan, providing greater flexibility and fewer restrictions. The greatest advantage of the NQSO plan over the ISO plan, however, may well be in its cost. The issuing company receives a compensation deduction under an NQSO plan. As a result, the company's cash flow will be enhanced by the tax savings and the inflow of cash from the exercised options. A portion of this cash flow could be used to compensate those employees that exercise their options for a share of the taxes owed on the ordinary income that must be recognized at the time of the exercise.

In essence, employers should not shy away from NQSO plans. They may be advantageous when it comes to costs, selectiveness and the desired results for a stock option plan. Most importantly, they may be instrumental in encouraging employees to achieve greater productivity by transforming them from employees to owners.
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Author:Talbott, John C.
Publication:The Tax Adviser
Date:Sep 1, 1992
Previous Article:Sec. 277 and AMT.
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