a. Design:
i. A stock option consists of the right of an employee, director or independent contractor to purchase stock of the company at certain times by paying a pre-set exercise price. Although options continue to be used by a number of businesses, they have fallen out of favor among many companies because they are not “full value grants” (like awards of restricted stock or restricted stock units) because payment of the exercise price will reduce the net value of the grants to the recipients. This usually results in a greater number of shares of stock being granted under an option than under a grant of restricted stock or restricted stock unit of equivalent value. Thus, the use of full value grants will have the effect of conserving the number of shares of stock granted under the company’s equity plan, something that proxy advisory firms such as ISS and Glass Lewis are very concerned with.
ii. Stock options consist of incentive stock options (“ISOs”) non‑qualified stock options (“NQOs”). As described below, there are certain tax advantages to individuals who receive ISOs; however, certain restrictions also apply to these grants which have made ISOs less attractive in recent years. I would be pleased to discuss these with you at your convenience.
iii. Options can be designed to expire at the times that the company determines at the time of grant; provided, however, that no ISO can be exercisable later than the tenth anniversary of its grant. Option grants can be also be designed to be exercisable only at the times and subject to the restrictions and conditions (such as time and/or performance vesting provisions) as the company may impose. Under most option plans, the exercise price may be paid in cash, in shares of the company’s stock having a fair market value equal to the exercise price, by share withholding or a combination of the foregoing.
iv. To avoid the application of the Code Section 162(m) limitations (to the extent avoidable)[1], and for options to qualify (A) as ISOs and (B) for the exception to the restrictions imposed on non-qualified deferred compensation under Section 409A of the Code, the exercise price (per share of stock) of each option grant must at all times be no less than the fair market value of one share of the underlying stock determined on the date the option is granted. It is also important to note that if the exercise price of the stock underlying the option is generally less than 20% of the fair market value of the stock on the date of grant, the option holder will likely have to include the net value of the option in his or her gross income for the year of grant under classic constructive receipt rules.
b. Federal Income Tax Implications:
i. Impact on Option Holders:
1. Grant. There is no federal income tax impact on the option holder solely by reason of the grant of ISOs and NQOs.
2. Exercise. The exercise of an ISO is not a taxable event for regular federal income tax purposes if certain requirements are satisfied. However, the exercise may give rise to an alternative minimum tax liability. Upon the exercise of an NQO, the option holder generally will recognize ordinary income in an amount equal to the excess of the fair market value of the shares of the company’s stock at the time of exercise over the amount paid as the exercise price. The ordinary income recognized in connection with the exercise by an option holder of an NQO will be subject to both wage and employment tax withholding. The option holder’s tax basis in the shares acquired pursuant to the exercise of an option will be the amount paid upon exercise plus, in the case of an NQO, the amount of ordinary income recognized by the option holder upon exercise.
3. Dispositions. If an option holder disposes of shares of the company’s stock acquired upon the exercise of an option in a taxable transaction, the option holder will recognize capital gain or loss in an amount equal to the difference between his or her basis in the shares sold and the total amount realized upon the disposition. Under current law, any capital gain or loss will be long‑term depending on whether the shares of the company’s stock were held for more than one year from the date the shares were transferred to the option holder.
ii. Impact on the Company:
1. There is no federal income tax impact on the company by reason of the grant of ISOs or NQOs or, generally, upon the exercise of ISOs (other than disqualifying dispositions).
2. At the time the option holder recognizes ordinary income from the exercise of an NQO, the company will be entitled to a federal income tax deduction in the amount of the ordinary income so recognized (as described above), provided that the company timely satisfies the reporting and disclosure obligations described below.
3. The company will be required to report to the Internal Revenue Service any ordinary income recognized by an option holder by reason of the exercise of an NQO or certain dispositions of the company's stock acquired pursuant to an ISO.
[1] Please note that the “performance-based compensation” exception to the application of the deduction limitations set forth under Section 162(m) of the Code only applies to contracts and agreements in effect on November 2, 2017.