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Taxability of Stock Options
If Morris and Brad resolve their negotiations through the use of stock options, careful tax analysis is
again necessary. The Code treats stock options in three different ways, depending upon the
circumstances, and some of these circumstances are well within the control of the parties (see Exhibit
9.5).
If a stock option has a “readily ascertainable value,” the IRS will expect the employee to include in
his or her taxable income the difference between the value of the option and the amount paid for it (the
amount paid is normally zero). Measured in that way, the value of an option might be quite small,
especially if the exercise price is close or equal to the then fair market value of the underlying stock.
After all, the value of a right to buy $10 of stock for $10 is only the speculative value of having that
right when the underlying value has increased. That amount is then taxed as ordinary compensation
income, and the employer receives a compensating deduction for compensation paid. When the
employee exercises the option, the tax code imposes no tax, nor does the employer receive any further
deduction. Finally, should the employee sell the stock, the difference between the price received and
the total of the previously taxed income and the amounts paid for the option and the stock is included
in the employee‟s income as capital gain. No deduction is then granted to the employer, as the
employee‟s decision to sell the stock is not deemed to be related to the employer‟s compensation
policy.
Exhibit 9.5 Taxation of stock options.
This taxation scenario is normally quite attractive to employees, because they are taxed on a rather
small amount at first, escape tax entirely upon exercise, and then pay tax on the growth at a time when
they have realized cash with which to pay the tax at a lower long-term capital gain rate. Although the
employer receives little benefit, it has cost the employer nothing in hard assets, so any benefit would
be a windfall.
Because this tax scenario is seen as very favorable to the employee, the IRS has been loath to allow
it in most cases. Generally, the IRS will not recognize an option as having a readily ascertainable
value unless the option is traded on a recognized exchange. Short of that, a case has occasionally been
made when the underlying stock is publicly traded. But the IRS has drawn the line at options on
privately held stock and at all options that are not themselves transferable. Since Morris‟s corporation
is privately held and since he will not tolerate Brad‟s reserving the right to transfer the option to a
third party, there is no chance of Brad‟s taking advantage of this beneficial tax treatment.