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Broad Stock Options: Incentive
Options
There
are two types of broad employee stock options
that receive special treatment under the Internal
Revenue Code: incentive stock options and employee
stock purchase plans. There is no recognition
of income on option grant or on the exercise
of the option under either of these programs
for employee ownership. Additionally, if the
stock is disposed of after completion of the
statutory holding period, any appreciation will
be taxed as capital gain.
With
an incentive stock option, a company grants
the employee an option to purchase stock at
some time in the future at a specified price.
With an incentive stock option, there are restrictions
on how the option is to be structured and when
the option stock can be transferred. The employee
will exercise the option at some time when the
value of the option stock is greater than the
exercise price of the option. As the value of
the stock increases relative to the option price,
the employee has the potential to benefit from
the increase in the option stock's value over
the option exercise price. The employee does
not recognize ordinary income at option grant
or exercise (although the spread between the
option price and the option stock's fair market
value constitutes an item of adjustment for
alternative minimum tax purposes), and the company
cannot deduct the related compensation expense.
The employee is taxed only upon disposition
of the option stock. The gain is all capital
gain for a qualifying disposition. For a disqualifying
disposition, the employee will recognize ordinary
income as well as capital gain.
Incentive
stock options enable employees to share in the
appreciation and the value of the stock, and
provide the employer with more flexible arrangements
than allowed in a qualified retirement plan.
They may be designed so that employees may put
their capital at risk or so that employees are
given assistance in financing the exercise price
through the use of stock and option exercise
programs and employee loan programs. Employees
are able to realize the compensatory gains on
the options while employed, rather than having
to wait until termination of employment. Options
also provide executives with the opportunity
to realise unlimited gains. In addition, the
employer can tailor incentive stock options
to benefit only those employees whose action
may impact the stock's value, which would not
be possible in a qualified retirement plan.
From
the employer's standpoint, the most important
advantage of incentive stock options is that
they enable a company to attract and keep talent
without draining cash flow by paying high salaries.
Incentive stock options should be especially
helpful for cash-poor companies with good growth
prospects. From the employee's point of view,
an employee receiving an incentive stock option
recognizes no taxable income upon its receipt
or exercise. If the incentive stock option is
exercised more than three months after the employee
has left the employ of the company granting
the option, however, this favourable tax treatment
is not available.
Upon
a qualifying disposition, the employee recognizes
capital gain, measured by the difference between
the option price and the sale proceeds. After
the Tax Reform Act of 1986, which substantially
reduced the progressive nature of the individual
taxpayer's rate structure and repealed favorable
tax rates for capital gains, the tax advantage
realised upon disposition of the stock was reduced.
After the Revenue Reconciliation Act of 1993,
however, there was a substantial differential
between the top marginal tax rates for capital
gains at 28% and ordinary income at 39.6%. After
tax reforms in 2003, the gap has widened further
in many situations in which favourable rates
of capital gains tax apply..
ISOs can however have
a major disadvantage for the employee because
the spread between the purchase and grant price
is subject to the AMT (Alternative Minimum Tax).
The AMT was enacted to prevent higher-income
taxpayers from paying too little tax because
they were able to take a variety of tax deductions
or exclusions (such as the spread on the exercise
of an ISO). It requires that taxpayers who may
be subject to the tax calculate what they owe
in two ways. First, they figure out how much
tax they would owe using the normal tax rules.
Then, they add back in to their taxable income
certain deductions and exclusions they took
when figuring their regular tax and, using this
now higher number, calculate the AMT. These
"add-backs" are called "preference
items" and the spread on an incentive stock
option (but not on an NSO - Unqualified Stock
Option, see below) is one of these items. For
taxable income up to $175,000 or less, the AMT
tax rate is 26%; for amounts over this, the
rate is 28%. If the AMT is higher, the taxpayer
pays that tax instead. If
the amount paid under the AMT exceeds what would
have been paid under normal tax rules that year,
this AMT excess becomes a "minimum tax
credit" (MTC) that can be applied in future
years when normal taxes exceed the AMT amount.
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