A stock option is the right to buy a designated number of shares of company stock at a fixed price within a specific period of time. The stock option is usually subject to conditions outlined in an agreement, which sets forth terms like when the shares will be earned ("vested") and when the right to exercise the option (purchase shares) expires.
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Overview of Stock Options
There are two types of stock options that companies may offer as part of their stock plans: Incentive Stock Options and Nonqualified. The recipient of a stock option grant is commonly referred to as an "optionee."
Incentive Stock Options
Incentive Stock Options (ISOs) are intended to qualify for special tax treatment available under Section 422 of the Internal Revenue Code.
If ISOs have been granted correctly, U.S. optionees generally are not required to include any amount in income for regular tax purposes as the result of the grant or exercise of ISO, provided that they also meet the holding requirement.
Incentive Stock Option Grant Requirements
In order for a grant to qualify for preferential tax treatment under Section 422, ISOs must meet the following criteria:
Offered to Employees Only
ISOs can be granted only to employees of the company. In addition, the option holder must remain an employee throughout the life of the option and must either be an employee on the date the option is exercised or must have terminated not more than three months prior to the exercise date.
Note that the actual length of time an ISO is exercisable after termination of employment should be stipulated under either the option agreement or the plan. There is no legal requirement that ISOs be exercisable for three months after termination of employment. But where ISOs are exercisable for a period of longer than three months, the option must be exercised within three months for the exercise to receive preferential treatment under Section 422.
The three-month period in which an option retains ISO status after termination of employment is extended to 12 months in the case of termination due to disability.
See also the discussion below on the treatment of ISOs upon death in the section titled “Transferability.”
A modification upon termination to extend the period over which an ISO is exercisable is considered a cancellation and regrant of the option. Because the option will no longer be an employee at the time of modification (and, thus, at the time the option is regranted), this will immediately disqualify the option from ISO treatment.
Plan Must Be Approved by Shareholders
ISOs must be granted under a shareholder-approved plan. Shareholder approval of the plan is typically obtained before any ISOs are granted, but it is permissible for ISOs to be granted prior to shareholder approval of the plan, provided that shareholders approve the plan not more than 12 months after the plan is adopted by the board.
In addition to being approved by shareholders, the plan must meet the following conditions:
- Specify the aggregate number of shares which may be issued under ISOs.
- Identify the employees or class of employees eligible to receive options.
- Expire within the earlier of ten years of the date the plan is adopted by the board or the date the plan is approved by shareholders.
Exercise Price Limitations
ISOs must have an exercise price that is not less than the fair market value of the stock on the date of grant. Where the recipient of an ISO is a 10% shareholder at the time of grant, the exercise price must be at least 110% of the fair market value at the time of the grant.
Contractual Term Limitations
ISOs must not be exercisable for more than ten years from the date of grant. Where the recipient of an ISO is a 10% shareholder at the time of grant, the option term must be limited to no more than five years from the date of grant
ISOs, by their terms, may not be transferrable except by will or the laws of descent and distribution.
Where permitted under the plan and grant agreement, ISOs may be exercised by the estate or beneficiary of the employee after the death of the employee. Provided the ISO is not modified after the employee’s death, there is no limit on how long the option can qualify for ISO treatment (although the option must be exercised within the time period stipulated under the plan and award agreement).
Under Section 422(d), the total aggregate fair value of ISOs that become exercisable for an individual employee for the first time within a calendar year under all plans may not exceed $100,000. The fair value of the shares for the purposes of determining the aggregate value of shares within a calendar year is the value as of the grant date. Any shares that become exercisable within a calendar year that cause the value of the aggregate number of shares vesting to exceed $100,000 will no longer qualify for preferential tax treatment as ISO shares.
Additional information on ISOs, including taxation and tax reporting calculations can be found in the NASPP's Guide to Incentive Stock Options.
Nonqualified Stock Options
Nonqualified stock options, or NQSOs, derive their name from the fact that neither the stock options nor the underlying option shares satisfy the statutory requirements, or "qualify," for preferential tax treatment under the federal income tax laws. Since nonqualified stock options are not defined in the Internal Revenue Code, they are sometimes referred to as "nonstatutory stock options."
Characteristics of Nonqualified Stock Options
Because there are only limited requirements governing the grant of NQSOs in the Internal Revenue Code, companies have a great deal of flexibility in how the terms and conditions that they attach to these awards. Here are some of the characteristics that apply to NQSOs:
- Grants are not limited to employees.
- Although not required, options can be transferable under a variety of circumstances (death, divorce, for estate planning purposes, etc.). At least one public company has granted NQSOs that are tradable under limited circumstances.
- Option price equal to or greater than FMV on the date of grant
- No taxable income is recognized on the date of grant.
- Difference, if any, between the option price and the FMV of the company's stock on the date of exercise is compensation income to the optionee.
- Withholding tax obligation arises at the time of exercise.
- Company receives a tax deduction is equal to the compensation income recognized by the employee.
Additional information on nonqualified stock options can be found in the NASPP's Guide to Nonqualified Stock Options.