Stock option plans generally fall into one of two categories:
Qualified Incentive Stock Options (ISO)
or Nonqualified Stock Options Plan (SOP).
Under an ISO, there is no taxable transaction when the option is granted
and generally no taxable transaction when the option is exercised, but (and
this is a really big but) the bargain element of the ISO -- the difference
between the option price and the Fair Market Value at the time of exercise
-- is a tax preference item for the Alternative Minimum Tax computation.
When the stock is eventually sold, as long as the holding requirements have
been met (i.e., the stock must be held for at least two years from the date
the option was granted, and at least one year from the date the option was
exercised), the gain from the sale is treated as a capital gain. Sale prior
to the end of the holding period shifts the amount of the bargain element
to ordinary income.
Under an SOP, the granting of an option is not a taxable event; however,
ordinary income is recognized at the time the option is exercised. The amount
of ordinary income is the difference between the option price and the Fair
Market Value of the stock at the time of purchase. The ordinary income is
added to the basis of the stock purchased, and any subsequent gains from
the sale of the stock are capital gains.
Ain't tax laws fun??? And Congress wonders why the people are screaming for
simplification. Let's try some simplification in the form of an example:
-- On January 1, 1994, as part of a qualified ISO, your company grants you
an option to buy up to 100 shares of stock at $5 per share.
-- On September 1, 1994, when the Fair Market Value of the stock is $8 per
share, you exercise the option and purchase all 100 shares for $500.
-- On February 1, 1996, you sell all 100 shares for $10 per share, or a grand
total of $1,000, realizing a gain of $500.
Since the holding requirements have been met, the entire $500 gain is treated
as a long-term capital gain. In 1994 (the date of the exercise), you would
have reported $300 (the bargain element) as a tax preference for Alternative
Minimum Tax. If the shares would have been sold before the end of the holding
period, $300 of the gain (the bargain element) would be taxed as ordinary
income, and the remaining $200 would be taxed as capital gains.
Under a non-qualified SOP, using the same facts as in the example above,
you would be taxed on the $300 (bargain element) in 1994 at the time the
option was exercised. Your basis in the stock would then be $8 per share
($5 actually paid PLUS $3 subject to tax), and the remaining gain of $200
would be long term capital gain.
Options: A great way to compensate employees and drive tax preparers nuts
at the same time.
- Article 24
