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Taxation Stock Options Part I
by Peter Soh, CPA

As an e-entrepreneur, you want to attract to the best and the brightest and retain them. Consider stock options to give your employees equity ownership, so they can win too.

You will need to consider the following:

• What types of stock option plans exist?
• What are the tax consequences for the company and the employee?

Taxation
In general, an employee or independent contractor must recognize compensation income when the stock option has a readily ascertainable fair market value and any significant restrictions have lapsed. Usually, the stock of private companies does not have a readily ascertainable value until they become public or get sold. Usually, the exercise date (the date the employee exercises his/her right to purchase the stock) is the date the stock has a readily ascertainable fair market value, and thus becomes compensation income for the employee. If the employee must fulfill a required amount of service (i.e. a vesting schedule), then the date the stock becomes taxable for the employee will be the date those restrictions lapse, and the employee will not have to forfeit the stock back to the employer. Remember compensation income can be taxed as high as 39.6%. Ouch!

For example: On 1/1/99, EmployerCorp grants C, a key employee, options to purchase 100,000 shares of its stock at $1/share for a 10-year period. Also, the determinable fair market value is $1/share and remains that way until it goes public. Employee C must work 5 years or he forfeits the stock back to EmployerCorp. The company goes public on 12/31/99 and trades for $100/share. On 1/1/00, C exercises his option to purchase the stock at $10/share. He now has $100,000 of his company's stock. On 1/1/04, he has worked 5 years and can keep his stock without substantial forfeiture. The stock's value is $200/share on 1/1/04. C holds all of the stock for 1 year and sells all of it on 1/1/05 for $250/share.

Consequences: C must recognize compensation income for $19,000,000 on 1/1/04($200 FMV-$10 Exercise Price x 100,000 shares). C would pay $7,524,000 of federal income taxes and EmployerCorp will get a tax deduction for $19,000,000. On 1/1/05, C will recognize a long term capital gain of $5,000,000 and pay taxes of $1,000,000. C's net cash inflow will be the following: Compensation Inc. $19,000,000 Federal Taxes $(7,524,000) Capital Gain $ 5,000,000 Capital Gain Taxes $(1,000,000 Net Cash Inflow $15,476,000

Section 83b Election
An employee may elect to accelerate the taxation arising from the exercise of a stock option even though the employee is subject to restrictions if he/she makes a 83b election. This acceleration feature will allow the employee to treat the spread on the exercise date as compensation income and any further appreciation will be subject to capital gains taxes. Let's look at our example.

On 1/1/99, if C exercises his option to purchase 100,000 shares of stock at $1/share and make the 83b election, he will actually pay no taxes because there is no spread. The FMV is also $1/share. He will pay $100,000 to EmployerCorp for the stock and will now have a basis of $100,000. On 1/1/04, when the forfeiture provisions lapse, C can sell his stock for $2,000,000 and realize a gain of $1,900,000. He will pay $380,000 in capital gain taxes - long term capital gain rate is 20%. He will save $372,400 in income taxes from this election. EmployerCorp will receive a tax deduction of $100,000 on 1/1/99 but will not receive an income tax deduction in 1/1/2004.

Caveat
The 83b Election works great for stocks that have a potential for capital appreciation and a low spread on the exercise date of the stock option.

NSO Summary Table:
Grant Date - date the option is given to the employee Exercise Date - date the option is utilized to receive the stock Vested Date - date the stock is no longer subject to forfeiture Sell Date - date the stock is sold 1/1/99 1/1/00 1/1/04

Next time, we will discuss incentive stock options and employee purchase plans.

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