632598256894

The second tax scenario attaches to stock options that do not have a readily ascertainable value.
Since, by definition, one cannot include their value in income on the date of grant (it is unknown), the
Internal Revenue Code allows the grant to escape taxation. However, upon exercise, the taxpayer must
include in income the difference between the then fair market value of the stock purchased and the
total paid for the option and stock. When the purchased stock is later sold, the further growth is taxed
at the applicable rate for capital gain. The employer receives a compensation deduction at the time of
exercise and no deduction at the time of sale. Although the employee receives a deferral of taxation
from grant to exercise in this scenario, this method of taxation is generally seen as less advantageous
to the employee, since a larger amount of income is exposed to ordinary income rates, and this
taxation occurs at a time when the taxpayer has still not received any cash from the transaction with
which to pay the tax.
Recognizing the harshness of this result, Congress invented a third taxation scenario, which attaches
to incentive stock options (ISOs). The recipient of such an option escapes tax upon grant of the option
and again upon exercise. Upon sale of the underlying stock, the employee includes in taxable income
the difference between the price received and the total paid for the stock and option, and pays tax upon
that amount at long-term capital gain rates. This scenario is extremely attractive to the employee, who
defers all tax until the last moment and pays at a lower rate. Under this scenario, the employer receives
no deduction at all, but since the transaction costs the employer nothing, that is normally not a major
concern. Lest you believe that ISOs are the perfect compensation device, however, be aware that
although the employee escapes income taxation upon exercise of the option, said exercise may be
deemed taxable under the alternative minimum tax (described later in this chapter).
The tax code imposes many conditions upon the grant of an incentive stock option. Among these
are that the options must be granted pursuant to a written plan setting forth the maximum number of
shares available and the class of employees eligible; only employees are eligible recipients; the
options cannot be transferable; no more than $100,000 of underlying stock may be initially exercisable
in any one year by any one employee; the exercise price of the options must be no less than the fair
market value of the stock upon the date of grant; and the options must expire substantially
simultaneously with the termination of the employee‟s employment. Perhaps most important, the
underlying stock may not be sold by the employee prior to the expiration of two years from the option
grant date or one year from the exercise date, whichever is later.
This latter requirement has led to what was probably an unexpected consequence. Assume that
Plant Supply has granted an incentive stock option to Brad. Assume further that Brad has recently
exercised the option and has plans to sell the stock he received. It may occur to Brad that by waiting a
year to resell, he will be risking the vagaries of the market for a tax savings that cannot exceed 20%
(the difference between the maximum income tax rate of 35% and the maximum capital gain rate of
15%). By selling early, Brad will lose the chance to treat the option as an incentive stock option, but
will pay, at worst, only a marginally higher amount of tax at a time when he does have the money to
pay it. Furthermore, by disqualifying the options, he will be giving his employer a tax deduction at the
time of exercise. An enterprising employee might go so far as to offer to sell early in exchange for a
split of the employer‟s tax savings.
Tax Impact on Restricted Stock