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Nonqualified Stock Options

What is it?

A stock option is a written offer from an employer to sell stock to an employee at a specified price within a specific time period. A stock option can be a valuable form of additional compensation to your employees, because it provides your employees with the benefits of company ownership along with potential tax benefits. When you offer your employees stock options, you provide them with the opportunity to purchase shares of your company's stock at a price that may be below the stock's fair market value (FMV). If your employee exercises the stock options, he or she purchases the shares at the lower option price, resulting in a windfall to your employee if the stock's value increases. Since stock options usually last for a long period of time (e.g., 10 years), your employee does not have to sell or purchase the stock when it would be economically unwise. As a result, your employee can avoid economic loss. As for taxation of the stock option, the employee is usually not taxed when you offer him or her the stock option. Instead, taxation is deferred until the time the employee exercises the option. There are two types of stock options that you can offer to your employee: incentive stock options and nonqualified stock options, also known as nonstatutory stock options. This discussion will focus on nonqualified stock options.

Nonqualified stock options (NQSOs)

In general

Unlike an incentive stock option (ISO), which must meet certain requirements under Internal Revenue Code Section 422 to achieve its tax-favored status, a nonqualified stock option (NQSO) is a stock option that either does not meet statutory requirements or specifically states that it is an NQSO. Although an employee who participates in an NQSO is not entitled to the same tax benefits as an ISO, it can still be an attractive alternative to an ISO, because it does not have to follow the requirements of Internal Revenue Code Section 422. As a result, an NQSO plan is an extremely flexible form of employee compensation, allowing you to configure the plan to meet both your and your employees' needs.

Taxation of nonqualified stock options

Generally, if an option does not have a readily ascertainable FMV at the time it is granted to the employee, it is not treated as taxable income to the employee at the date of the grant. Instead, the option is treated as taxable income when your employee purchases the option shares. The amount of taxable income is the difference between the FMV of the shares at the date of purchase and the option price (the amount your employee pays for the shares). As for employer tax benefits, you do not receive a deduction when the option is granted. Instead, you receive a deduction in the same year the employee has taxable income as a result of exercising the option. The amount of the deduction is the same as the amount of the employee's taxable income.

Example(s): Jeff was given an option in Year 1 to purchase 500 shares of Acme, Inc. at the current market price of $50 per share. Jeff could exercise the option at any time during the next three years. In Year 2, he purchased 250 shares for $12,500 (250 x $50). The FMV of the shares at the time of purchase was $18,750 (250 x $75), so Jeff has $6,250 ($18,750 - $12,500) in taxable income. In addition, Acme, Inc. can deduct $6,250 for Year 2. If the option does have a readily ascertainable FMV at the time of the grant, it is taxed at that time, while the employer receives a corresponding tax deduction.

Tip: Generally, an option has a readily ascertainable FMV if the option can be traded on an established market.

IRC Section 409A

IRC Section 409A contains complex rules that govern nonqualified deferred compensation (NQDC) plan deferral elections, distributions, funding, and reporting. If a NQDC plan fails to satisfy Section 409A's requirements participants may be subject to current income tax, as well as an interest charge and 20 percent penalty tax. Nonqualified stock options plans may be subject to IRC Section 409A.

Advisory services are offered through Frontier Financial Planning & Cap. Mgmt, Inc, or Creative Financial Designs Registered Investment Advisors. All securities offered through CFD Investments., a registered broker / dealer, Member FINRA & SIPC, 2704 South Goyer Road , Kokomo , IN 46902 (800) 745-7776. Frontier Financial Planning & Cap. Mgmt., Inc. is neither a subsidiary of or controlled by the CFD companies.

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Prepared by Broadridge Investor Communication Solutions, Inc. Copyright 2015.