Companies oftentimes give different types of stock options incentive to their employees by offering an option to buy company stocks at a discount. This normally forms part of the employee's compensation package, which in effect, gives employees the right to own a part of the company.
Being a part owner and a stakeholder, employee performance is boosted, which ultimately equates to company profitability. Among the inherent features of these types of stock option are: built-in discount, tax advantage offered, and earning potentials. There are different stock options available which are wholly dependent on the issuing company.
First, would be the non-qualified stock options (NQSOs) plan that is given to all tiers of employees — from top management to front line employees. Another, is the incentive stock scheme (ISO) that is only given to top management and is given preferential tax incentives.
ISOs are usually given from a prescriptive date to an exercise date, where employees exercise the option in the mandatory 10 years from the date of the grant. After the lapse of 10 years, the option expires immediately. Once availed of, the employees can either keep it or sell the stock in the financial markets.
To fully understand the concept behind these types of stock options, one would need a clear idea on the definition of terms.
Exercise and Exercise Price
This is the purchase of stock at the strike or grant price.
The difference between the market value of stock at the time of exercise and the grant price is called Spread.
The time frame given to employees to hold on to the stocks before its expiry date.
A requirement prescribed by the company before the option can be availed of (time of service and performance criteria).
There are two Stock Option types to choose from:
Incentive Stock Options (ISOs)
An ISO has its inherent plus side to it, that makes it attractive to employees as an investment vehicle. First, he does not pay any taxes at the time he exercises his option. He is not exempted, however, to pay the required tax if he opts to sell the shares in the future. Once the sale is consummated, capital gains tax are paid to the IRS, instead of an ordinary tax. However, there are certain conditions that is required by the IRS before an employee is deemed qualified for an ISO. These are:
The holding period is one year after the exercise and not less than two years after the grant date.
A pegged rate of $100,000 can only be exercised yearly by the company. The amount is quoted based on the grant price in any given year. Any amount in excess of this amount, would be treated as an NQSO. Only bona fide employees of the company are eligible to exercise the option.
This stock option type must be approved by the Board of Directors as to the number of shares, type of employees eligible, and be granted within ten years after the approval by the Board of Directors.
The period of exercise is ten years within the date of the grant, with employees owning more than 10% voting power of the company's outstanding stock, must be given an exercise price of 110% based on market value at the time of the exercise, within a grace period of five years.
If all requirements for the ISOs are met, the sale is called a qualifying disposition, and the employee must pay a corresponding capital gains tax on the difference between the grant and the sale price. The company does not take a tax cut when there is a qualifying disposition.
If, however, there is a disqualifying disposition, like when an employee exercises and sells the shares before meeting the required holding period, the spread on the exercise is taxable to the employee at ordinary income tax. Any increase or decrease in the shares' value is taxed for capital gains.
Any time an employee exercises the ISOs and does not sell the shares by the end of the year, the spread on the option at exercise is slapped an alternative minimum tax (AMT). So even though the shares may not have been sold, this requires the investor to add back whatever gains he made on the exercise, along with other AMT preference items, to ascertain whether an alternative minimum tax payment is due
Nonqualified or Nonstatutory Stock Options (NQSOs)
NSO is an offer by the company to its employees to buy its shares of stocks at a price below its prevailing market price. It is the prerogative of the employee whether to take this offer or not.
The NQSOs and ISOs are both issued in a fairly straightforward manner. The company offers its employees the right to buy a certain number of shares within the offering period at a given price stated at the grant. If the price of the stock rises or remains the same during the grant period, he can exercise his options at his own free will. If prices fall below after the date of the grant, he may either wait it out or allow it to expire.
Excercising the Option
Upon the exercise of the option, the employee earns from the transaction through the following:
The shares are bought in cash and the employee recoups his investment upon the sale of the stock.
The exercise wherein a local brokerage firm handles the purchase of the stocks for the employees, and sells the same stocks at the current market price at the same day. Upon consummation, the loaned amount, commissions, and other charges are deducted and with the remaining balance given back to the employees.
Stock Swap Basis
The employee who already owns shares of stocks with the company, delivers it to the brokerage firm to cover for the expenses related to the purchase of options.
NQSOs are taxed in the same manner as the ESPPs (Employee Stock Purchase Programs) where no tax is paid during the vesting period. Capitals gains tax are paid on the sale of the shares. As a consequence, money earned during the sale must be reported in the employee's' W-2 with federal taxes withheld at at 25% standard rate. Any gain or loss from the transaction is reported either as short or long term capital gains or loss.
There are two types of incentive options given by companies: Incentive Stock Options (ISOs) are granted to employees and Non-Qualified Stock Options (NQSOs) are granted to everyone interested, like employees, Board of Directors, Stockholders, and company consultants.
The difference between the two options lies basically on the payment of taxes to the IRS. With ISO, the federal income tax is paid when exercising the option. While ordinary income tax on the NQSO is recognized and computed on the difference between the prevailing market value of the share vis-a-vis the exercise price. As to withholding tax, ISOs have a minimum tax that needs to be paid upon exercise while the NQSOs are subjected to the payment of withholding tax.
Tax treatment for both options differ. For ISO, if the option is held after a year of the date of the exercise, and for more than two years after the date of the grant, any gain or loss on the transaction will be treated either as long term capital gain or loss. If disposed earlier, the ISO will be treated as an NQSO, subjected to ordinary tax on any gains derived from the disposition.
A company may be given a deduction for payment of compensation upon the exercise of the NQSO. For an employee who realizes ordinary income upon early disposition of an ISO or a disqualifying disposition, a corresponding deduction on compensation shall be deducted from the company. However, in case the employee holds unto the ISO for the entire holding period, the company will not be entitled to any deduction in tax.
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