More and more employers are granting stock options to employees as part of their compensation packages. From the tax standpoint, there are two kinds of options—statutory and nonstatutory. “Incentive Stock Options,” or ISOs, as they are commonly known, are statutory options, because they are specifically provided for in the Internal Revenue Code and are subject to numerous qualification requirements. Options that don’t meet these requirements are nonstatutory options, also known as nonqualified options. Both kinds of options have tax advantages, but there are quite a few differences between them. Here’s some basic information on the taxation of compensatory stock options that may help you better understand how best to benefit from them.

Option grant: If you have incentive stock options (ISOs), you are not taxed on option grant. If you have nonstatutory options, you are taxed on option grant only if the options have a “readily ascertainable” fair market value at grant, which is seldom the case. IRS rules say that options don’t have a readily ascertainable value at grant unless they are actively traded or are immediately transferable, fully exercisable, and the options and the option stock are unrestricted. In addition, the value of the “option privilege” must be readily ascertainable. In the unlikely event that a nonstatutory option is taxable at grant, you have compensation income at that point.

Option exercise: No regular income tax is owed on the exercise of an ISO. Tax isn’t owed until the stock is sold. However, the bargain element at exercise, which is the difference between the value of the option stock at exercise and the (lower) price you pay for it is considered to be income when figuring your alternative minimum tax (AMT). Even if you’re usually not subject to the AMT, exercising ISOs may push you into its range. (If you are subject to the AMT in the year you exercise ISOs, you may be entitled to a tax credit against your regular income tax in some later year when you’re not subject to AMT.) Under current rules, an ISO isn’t subject to social security and Medicare (FICA) tax at the time of exercise, although IRS may change this rule after 2002.

When you exercise a nonqualified option that wasn’t taxed at grant, you’re subject to tax at ordinary income rates at exercise on the difference between the value of the option stock at that time and the price you paid for it (plus any price you may have paid for the option, although generally that will be zero). This is compensation income that is subject to payroll taxes and income tax withholding. Taxes may be withheld from your salary or other compensation income, or you may have to sell some of the stock to cover the withholding or make some other arrangement with your employer. However if the option stock is nontransferable or subject to a substantial risk of forfeiture, you aren’t charged with compensation income until those restrictions no longer exist. In that case, you can choose to pay tax on exercise so that all gain from that point on would be capital gain.

Sale of option stock: When you sell stock acquired through the exercise of an incentive stock option (ISO stock), you generally are taxed at favorable long-term capital gain rates on the difference between the price you paid for the stock and the amount you realize on its sale. However, if you sell the stock within two years of the option grant or within one year of the option exercise, you’re hit with compensation income to the extent of your bargain element at exercise. The balance of your gain is capital gain, which will be taxed at favorable rates if you’ve held the stock for more than one year on the sale date. Although the sale is taxable, no tax will be withheld from your paycheck. IRS may change the rule on withholding after 2002.

When you sell stock acquired by exercise of a nonqualified option, you have capital gain if you were subject to tax either at option grant or exercise, or when restrictions on your option stock lapsed. Otherwise, you have compensation income at the time of the sale.

Gifts of options: Some people would like to give stock options to family members as part of their overall estate planning. (Transferring property before it increases in value helps lower or eliminate estate and gift taxes.) This can’t be done with ISOs, because they can’t be transferred during the optionee’s lifetime and can’t be exercised by anyone but the optionee during his or her life. Nonqualified options have an edge here if the option plan allows options to be transferred to family members, as many plans now do. However, the IRS has ruled that an option transfer isn’t complete for gift tax purposes until the option is no longer conditioned on the performance of future services. That usually means that the gift will be subject to gift tax at a time when the option’s value has increased. If you do make a gift of a nonqualified option, you won’t shift the compensation income from its exercise to the donee. You will be charged with some compensation income at the time of transfer, and will pick up the rest when the donee exercises the option. IRS also has issued some complicated rules for valuing gifts of nonqualified stock options.

As you can see, the tax rules for compensatory stock options are quite complex. Please contact us if you have additional questions about your options or if you would like to do some tax planning in relation to them.