STOCK OPTIONS

Stock options are either incentive stock options (ISOs) or non-qualified stock options (NSOs), sometimes referred to as non-statutory stock options.

 

“Incentive stock option” means an option granted to an individual for any reason connected with his employment by a corporation, if granted by the employer corporation or its parent or subsidiary corporation, to purchase stock of any of such corporations, but only if—

 

(1) the option is granted pursuant to a plan which includes the aggregate number of shares which may be issued under options and the employees (or class of employees) eligible to receive options, and which is approved by the stockholders of the granting corporation within 12 months before or after the date such plan is adopted;

 

(2) such option is granted within 10 years from the date such plan is adopted, or the date such plan is approved by the stockholders, whichever is earlier;

 

(3) such option by its terms is not exercisable after the expiration of 10 years from the date such option is granted;

 

(4) the option price is not less than the fair market value of the stock at the time such option is granted;

 

(5) such option by its terms is not transferable by such individual otherwise than by will or the laws of descent and distribution, and is exercisable, during his lifetime, only by him; and

 

(6) such individual, at the time the option is granted, does not own stock possessing more than 10 percent of the total combined voting power of all classes of stock of the employer corporation or of its parent or subsidiary corporation.

 

Such term shall not include any option if (as of the time the option is granted) the terms of such option provide that it will not be treated as an incentive stock option.

 

If there is granted to an employee or independent contractor (or beneficiary thereof) in connection with the performance of services, an option to which section 421 (relating generally to certain qualified and other options) does not apply, section 83(a) shall apply to such grant if the option has a readily ascertainable fair market value (determined in accordance with paragraph (b) of this section) at the time the option is granted. The person who performed such services realizes compensation upon such grant at the time and in the amount determined under section 83(a). If section 83(a) does not apply to the grant of such an option because the option does not have a readily ascertainable fair market value at the time of grant, sections 83(a) and 83(b) shall apply at the time the option is exercised or otherwise disposed of, even though the fair market value of such option may have become readily ascertainable before such time. If the option is exercised, sections 83(a) and 83(b) apply to the transfer of property pursuant to such exercise, and the employee or independent contractor realizes compensation upon such transfer at the time and in the amount determined under section 83(a) or 83(b). If the option is sold or otherwise disposed of in an arm's length transaction, sections 83(a) and 83(b) apply to the transfer of money or other property received in the same manner as sections 83(a) and 83(b) would have applied to the transfer of property pursuant to an exercise of the option. The preceding sentence does not apply to a sale or other disposition of the option to a person related to the service provider that occurs on or after July 2, 2003. For this purpose, a person is related to the service provider if -

 

(1) The person and the service provider bear a relationship to each other that is specified in section 267(b) or 707(b)(1), subject to the modifications that the language “20 percent” is used instead of “50 percent” each place it appears in sections 267(b) and 707(b)(1), and section 267(c)(4) is applied as if the family of an individual includes the spouse of any member of the family; or

 

(2) The person and the service provider are engaged in trades or businesses under common control (within the meaning of section 52(a) and (b)); provided that a person is not related to the service provider if the person is the service recipient with respect to the option or the grantor of the option.

 

Restricted stock plans provide employees with the right to purchase shares at fair market value or a discount, or employees may receive shares at no cost.

 

Stock appreciation rights (SARs) and phantom stock are bonus plans that grant right to receive a stock award based on the value of the company's stock - hence the terms "appreciation rights" and "phantom."

 

Employee stock purchase plans (ESPPs) allow employees to set aside money over a period of time (called an offering period), usually out of taxable payroll deductions, to purchase stock at the end of the offering period.

 

Per the IRS:

 

If you receive an option to buy stock as payment for your services, you may have income when you receive the option, when you exercise the option, or when you dispose of the option or stock received when you exercise the option. There are two types of stock options:

 

Options granted under an employee stock purchase plan or an incentive stock option (ISO) plan are statutory stock options.

 

Stock options that are granted neither under an employee stock purchase plan nor an ISO plan are nonstatutory stock options.

 

Refer to Publication 525, Taxable and Nontaxable Income, for assistance in determining whether you've been granted a statutory or a nonstatutory stock option.

Statutory Stock Options

 

If your employer grants you a statutory stock option, you generally don't include any amount in your gross income when you receive or exercise the option. However, you may be subject to alternative minimum tax in the year you exercise an ISO. For more information, refer to the Form 6251 Instructions. You have taxable income or deductible loss when you sell the stock you bought by exercising the option. You generally treat this amount as a capital gain or loss. However, if you don't meet special holding period requirements, you'll have to treat income from the sale as ordinary income. Add these amounts, which are treated as wages, to the basis of the stock in determining the gain or loss on the stock's disposition. Refer to Publication 525 for specific details on the type of stock option, as well as rules for when income is reported and how income is reported for income tax purposes.

 

Incentive Stock Option - After exercising an ISO, you should receive from your employer a Form 3921 (PDF), Exercise of an Incentive Stock Option Under Section 422(b). This form will report important dates and values needed to determine the correct amount of capital and ordinary income (if applicable) to be reported on your return.

 

Employee Stock Purchase Plan - After your first transfer or sale of stock acquired by exercising an option granted under an employee stock purchase plan, you should receive from your employer a Form 3922 (PDF), Transfer of Stock Acquired Through an Employee Stock Purchase Plan under Section 423(c). This form will report important dates and values needed to determine the correct amount of capital and ordinary income to be reported on your return.

 

Nonstatutory Stock Options

 

If your employer grants you a nonstatutory stock option, the amount of income to include and the time to include it depends on whether the fair market value of the option can be readily determined.

 

Readily Determined Fair Market Value - If an option is actively traded on an established market, you can readily determine the fair market value of the option. Refer to Publication 525 for other circumstances under which you can readily determine the fair market value of an option and the rules to determine when you should report income for an option with a readily determinable fair market value.

 

Not Readily Determined Fair Market Value - Most nonstatutory options don't have a readily determinable fair market value. For nonstatutory options without a readily determinable fair market value, there's no taxable event when the option is granted but you must include in income the fair market value of the stock received on exercise, less the amount paid, when you exercise the option. You have taxable income or deductible loss when you sell the stock you received by exercising the option. You generally treat this amount as a capital gain or loss. For specific information and reporting requirements, refer to Publication 525.