Stock Option Plans, Statutory & Non-Statutory Explained

Statutory Stock Option Plans.

Generally, property transferred to an employee in connection with services performed by the employee, results in ordinary income to the employee and a deduction to the employer. The Code does provide for special tax treatment for statutory stock options. The transfer of a statutory stock option to an employee has no tax consequence until the employee sells the stock. At that time, the employee pays capital gains tax (generally 15%) on the difference between the option price and the amount received. However, if the option price was less than the fair market value at the time the option was granted, the employee must recognize ordinary income (taxed up to 35%) on the difference between the option price and the fair market value at the time the option was granted.

As this is extremely confusing, an example is appropriate:

In year one, Employer (GM) gives Employee a five year statutory stock option to purchase one share of GM for $100. At the time, shares of GM have a fair market value of $100. In year 3, when shares of GM have a fair market value of $150, Employee exercises the option by paying GM $100 for the share of stock. In year five, Employee sells stock to a 3rd party for $200.

There is no tax consequence to any party in year one. In year three, Employee does not recognize any income. GM may have capital gain income equal to the $100 received minus GM's basis in the share. In year five, employee will have a $100 capital gain. GM does not receive a deduction.

Numerous requirements must be met to qualify as a statutory stock option. They provide a tax advantage for the employee in that tax on the appreciation is deferred until sale and the appreciation is taxed at a capital gains rate. There is no tax advantage for the employer, however, because no deduction is allowed.

If the employer's marginal tax rate is as high as the employees' marginal tax rate, there may be no overall advantage in utilizing a statutory stock option.

Non-statutory Stock Option Plans.

A non-statutory stock option plan is simply one that does not meet the requirements of a statutory plan. Generally, the employee will realize ordinary income at the time that the option is granted. Income recognition is deferred, however, if the employees' rights to the stock are not vested or if the stock does not have a readily ascertainable fair market value. Although income recognition deferral is a general goal of tax planning, in this case, the advantage of deferral must be weighed against the disadvantage that the appreciation in the stock is taxed as ordinary income (up to 35% rate) rather than capital gain (usually a 15% rate).

In some circumstances, the employee may elect to recognize income at the time that the option is granted. By doing so, appreciation in the stock is taxed at capital gains rate when the stock is sold.

Employers are entitled to a deduction equal to the ordinary income recognized by the employee. The employer may not claim this deduction until the year the employee includes the income in his/her return. The employer may also have capital gain or loss when the option is exercised equal to the option price minus the employer's basis in the stock.

It is more difficult to value a stock option than the underlying stock. The stock option value is based on the value of the underlying stock and the option privilege. Accordingly, it is more likely that a stock option will not have a "readily ascertainable value." This means that the stock option is less likely to be immediately taxable to the employee (and deductible to the employer). This also means that an employee is less likely to be eligible to make an election to immediately recognize income (to avoid ordinary income taxation on stock appreciation).

For this reason, it is sometime preferable to issue stock bonuses rather than stock options.