Stock Options



Statutory Stock Options: Overview

Incentive Stock Options (ISOs)
Tax Implications of ISOs for Employees
Tax Implications of ISOs for Employers
Requirements for ISOs
Advantages of ISOs

Nonqualified (Nonstatutory) Stock Options
Tax Implications-Generally
Readily Ascertainable Fair Market Value
Tax Implications for Employees
Tax Implications for Employers

Choosing Between Statutory and Nonstatutory (Nonqualified) Stock Options

Restricted Stock
Tax Treatment

Stock Appreciation Rights and Stock Options
Tax Implications for Employees
Tax Implications for Employers

Broad-based employee stock ownership, when combined with an effective communications program that is designed to create an employee ownership culture, can be a very dynamic tool for improving employee productivity and thereby increasing profitability and value. Although the focus of this chapter is not solely on “broad-based” employee stock options and related equity incentives, employers should keep this basic concept in mind when designing equity incentives for any employees.

Using employee stock ownership as an incentive compensation device provides many benefits for both the employer and the employee. Employee stock ownership provides an opportunity for employees to share in the growth potential of a company and thereby creates work incentives for the employees. The success of any employee stock ownership plan depends on the employer choosing the correct plan to achieve the desired objectives. In selecting an equity incentive plan, the employer must decide what group of employees it would like to reward, how closely it wants the reward to be tied to performance goals, what type of performance goals would work for the employees, and how the equity incentive plan could be used with incentives currently in place. An employer implementing an equity incentive plan should recognize the various needs and desires of its employees. Incentive compensation strategies for professional and scientific personnel, for example, may be more effective if performance reviews are tied to a project cycle rather than to an annual administrative cycle.

Implementing equity incentive plans can produce greater commitment from employees, provided they understand how their work affects a company’s value. Employee stock ownership generally gives employees more rights and responsibility, as well as risks and rewards, and encourages personal initiative.

A qualified retirement plan commonly known as an employee stock ownership plan (ESOP) is one device used to provide stock ownership to employees. An ESOP is a type of qualified retirement plan governed by the Employee Retirement Income Security Act of 1974, as amended (ERISA), and the Internal Revenue Code of 1986, as amended (the “Code”). There are numerous tax and other advantages for employees, companies, and existing shareholders when implementing an ESOP. ESOPs, however, have some limitations. For example, because ESOPs are tax-qualified plans, they must meet numerous coverage, nondiscrimination, distribution and other requirements of the Code. Furthermore, it is impossible to tailor ESOPs to benefit only a particular group of highly compensated employees. Finally, the Code’s ESOP distribution rules also require employees to make a market for company stock after employees depart.

A variety of equity incentive plans other than ESOPs are available for entrepreneurial growth companies to create employee incentives through pay-for-performance compensation systems. Stock options, performance shares, stock bonuses and stock purchase plans are increasingly used to provide incentive compensation at all organizational levels to merge the interests of employees, managers, and investors.

For employers implementing stock ownership plans in which the underlying stock is subject to regulation under the Securities Exchange Act of 1934, as amended (the “1934 Act”), additional considerations, including securities registration, proxy disclosure and short-swing profit liability, should be addressed before implementing a plan. In addition, the non-ESOP equity incentive plans presented in this chapter are generally not subject to the requirements of ERISA; however, any equity incentive plan that systematically defers payments to the termination of employment or retirement and that covers more than just highly compensated employees could trigger application of ERISA.


  • Exercise: To elect to purchase stock pursuant to an option.
  • Exercise date: The date that an individual or an entity purchases stock pursuant to an option.
  • Exercise price: The price at which stock can be purchased pursuant to a stock option.
  • Strike or striking price: Price at which an option (e.g., to purchase stock) is exercised. The price at which named stock can be put or called is ordinarily the fair market value when the option is written and is termed the “striking price.”
  • Grant date: The date on which an option is first offered to an individual or entity.
  • Incentive stock option: An option, qualifying for favorable tax treatment under section 422 of the Code, granted to an employee of a corporation to purchase company stock at a specified price for a specified period of time. Generally, there are no tax consequences until the stock is sold.
  • Nonqualified (nonstatutory) stock option: A stock option that does not qualify for favorable tax treatment under sections 421, 422 or 423 of the Code.
  • Qualified stock option: An option to purchase shares provided to an employee of the corporation under terms that qualify the option for special tax treatment under Code section 421 et seq.
  • Restricted stock option or restricted stock: An incentive or nonqualified stock option or stock that is subject to certain restrictions imposed by the employer; for example, employees may be required to sell their stock back to the employer upon termination of employment at the price they paid for the stock.
  • Section 423 stock purchase plan (sometimes called an “employee stock purchase plan” or ESPP): A plan under which a company allows employees to purchase stock at up to a 15% discount; purchasers receive favorable tax treatment if the plan meets certain rules.
  • Stock option: A right issued by a corporation to an individual or an entity to buy a given amount of shares of company stock at a stated price within a specified period of time.
  • Statutory stock option: A stock option (incentive stock option or section 423 stock purchase plan option) that qualifies for favorable tax treatment under sections 421, 422 or 423 of the Code.

Stock Options: Overview
Two types of employee stock options receive special treatment under the Code: incentive stock options and ESPPs, a kind of hybrid between a stock purchase plan and stock option plan. There is no recognition of income on the option grant or on the exercise of the option under either of these programs for employee ownership, provided that certain conditions under sections 421, 422 and 423 of the Code are satisfied, as discussed below. (Note: ESPPs are primarily stock purchase plans, albeit with a price discount feature. The main focus of this primer is on true stock options.) Additionally, if the stock is disposed of after completion of the statutory holding period, any appreciation will be taxed as capital gain.

Stock options are the most popular form of long-term compensation incentives for executives in major U.S. companies and are now being offered to most or all employees in many companies. They are very easy to administer, primarily because they do not require that the company establish any financial targets. Over 90% of the Fortune 1000 use stock options, according to a survey conducted by TPF&C, a Towers Perrin Company.

A recent ShareData (now E*Trade Business Solutions)/American Electronics Association Survey (1997) reached the following conclusions about the use of stock options after surveying 1,000 publicly-traded companies that use stock options:

  • 53% of respondents grant stock options to all employees
  • 88% of Information Technology companies grant stock options to all employees and, in companies with fewer than 100 employees, 68% grant stock options to all employees
  • 74% of companies with less than $50 Million in revenues grant stock options to all employees
  • Prevalence of stock options has increased since 1994 (previous study) and the smaller the company, the more likely it will have a broad-based stock option plan.

Incentive Stock Options
With an incentive stock option (ISO), a company grants the employee an option to purchase stock at some time in the future at a specified price. With an ISO, 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 exercise 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 the disposition of the option stock. The gain is all capital gain for a qualifying disposition. For a disqualifying disposition (i.e., one not meeting the rules specified below for a qualifying disposition), the employee will recognize ordinary income as well as capital gain.

A disposition of ISO stock is generally defined as any sale, exchange, gift or transfer of legal title of the stock. Section 424(c) of the Code, however, provides exceptions to this general definition. The exceptions include a transfer from a decedent who held ISO stock to an estate, a transfer of ISO stock by bequest or inheritance, an exchange of ISO stock in a nonrecognition transaction such as a reorganization, a transfer of stock between spouses incident to a divorce, a transfer of ISO stock into joint ownership and a transfer of ISO stock by an insolvent individual to a trustee in bankruptcy.

Tax Implications of ISOs for Employees
An employee receiving an ISO realizes no income upon its receipt or exercise. Instead, the employee is taxed upon disposition of the stock acquired pursuant to the ISO. A disposition of ISO stock generally refers to any sale, exchange, gift or transfer of legal title of stock. The tax treatment of the disposition of option exercise stock depends upon whether the stock was disposed of in a qualifying disposition within the statutory holding period for ISO stock. The ISO statutory holding period is the later of two years from the date of the granting of the ISO to the employee or one year from the date that the shares were transferred to the employee upon exercise.

Tax Implications for Employers
An employer granting an ISO is not entitled to a deduction with respect to the issuance of the option or its exercise. The amount received by the employer as the exercise price will be considered the amount received by the employer for the transfer of the ISO stock. If the employee causes the option to be disqualified (by disposing of his or her stock prematurely prior to the end of the requisite holding period), however, the employer usually may take a deduction for that amount recognized by the employee as ordinary income in the same year as the employee recognizes the income.

In addition, the employer that granted the ISO does not have any withholding obligation with regard to the ordinary income an employee recognizes upon a disqualifying disposition (the Internal Revenue Service [IRS] may change this position). The ordinary income resulting from the disqualifying disposition also is not considered wages for FICA or FUTA purposes.

An ISO generally is not subject to ERISA. Therefore, it is not subject to ERISA’s reporting requirements. The employer must furnish a statement to the employee who exercises an ISO, however, on or before January 31 of the year following the year of the ISO exercise stating details about the options granted.

Requirements for ISOs
For a stock option to qualify as an ISO (and thus receive special tax treatment under Code section 421(a)), it must meet the requirements of section 422 of the Code when granted and at all times beginning from the grant until its exercise. The requirements include:

  • The option may be granted only to an employee (grants to non-employee directors or independent contractors are not permitted) who must exercise the option while an employee or no later than three months after termination of employment (unless the optionee is disabled, in which case this three-month period is extended to one year).3 The stock option must be an option to purchase stock of the employer corporation or the stock of a parent or subsidiary corporation. The stock may be capital stock of any class of the corporation, including voting and nonvoting common or preferred stock. In addition, using special classes of stock that are authorized to be exclusively issued and held by employees is permissible.
  • The option must be granted under a written plan document specifying the total number of shares that may be issued and the employees who are eligible to receive the options. The plan must be approved by the stockholders within 12 months before or after plan adoption. The stockholders’ approval must comply with the charter, bylaws and state laws that regulate the stockholder approval required for the issuance of corporate stock. If there is no applicable authority, the plan must be approved by a majority of all outstanding voting stock (whether such votes are in person or by proxy) at a duly held stockholders’ meeting with a quorum present or by a method that would meet the applicable state law requirements for approval of actions requiring shareholder voting.
  • Each option must be granted under an ISO agreement, which must be written and must list the restrictions placed on exercising the ISO. Each option must set forth an offer to sell the stock at the option price and the period of time during which the option will remain open.
  • The option must be granted within 10 years of the earlier of adoption or shareholder approval, and the option must be exercisable only within 10 years of grant.
  • The option exercise price must equal or exceed the fair market value of the underlying stock at the time of grant.
  • The employee must not, at the time of the grant, own stock representing more than 10% of the voting power of all stock outstanding (including stock constructively owned through attribution pursuant to Code section 424(d)), unless the option exercise price is at least 110% of the fair market value and the option is not exercisable more than five years from the time of the grant.
  • The ISO agreement must specifically state that the ISO cannot be transferred by the option holder other than by will or by the laws of descent and that the option cannot be exercised by anyone other than the option holder.
  • The aggregate fair market value (determined as of the grant date) of stock bought by exercising ISOs that are exercisable for the first time cannot exceed $100,000 in a calendar year. To the extent it does, Code section 422(d) provides that such options are treated as nonqualified options.

An ISO plan may include other provisions that are not required as long as such provisions are not inconsistent with these requirements. Employers often include provisions enabling the employee to finance the exercise price. For example, the ISO plan can provide that the employee may pay for the exercise of his or her options with stock of the company. The ISO plan also may provide for tandem stock appreciation rights which will assist an employee in exercising options without cash (please refer to discuss of stock appreciation rights on page 20 of this chapter).

The initial ISO plan document should be drafted to include any desired provisions to be used presently and also in the future so that the ISO plan does not need to be modified to include any newly desired provisions. The ISO plan also should provide for amendments.

Advantages of ISOs
ISOs 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 can 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 realize almost unlimited gains. In addition, the employer can tailor ISOs to benefit particular employees, which would not be possible in a qualified retirement plan.

From the employer’s standpoint, the most important advantage of ISOs is that they enable a company to attract and keep talent without draining cash flow by paying higher salaries. ISOs should be especially helpful for cash-poor companies with good growth prospects. This is not as true anymore, however, as high-tech employees begin to expect high current compensation and substantial growth potential from options.

From the employee’s standpoint, an employee receiving an ISO recognizes no taxable income upon the ISO’s receipt or exercise. If the ISO is exercised more than three months after the employee has left the employ of the company granting the option, however, this favorable tax treatment is not available.

Upon a qualifying disposition, the employee recognizes capital gain, measured by the difference between the option exercise 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 realized upon disposition of the stock was reduced. As of this writing, there is once again a substantial differential between the top marginal rate for ordinary income (39.6%) and the 20% capital gains tax rate for those in the 28% to 39.6% tax brackets (of course, for those with a marginal tax rate of 15% for ordinary income, the capital gains rate is 10%). However, ISOs generally are not useful for broad-based stock option plans because most nonmanagerial employees will have ordinary income and capital gains rates that are very close. In any event, most employees in broad-based stock option plans do not hold onto their stock after exercise long enough to qualify for capital gains treatment.

Nonqualified (Nonstatutory) Stock Options
The term “nonqualified stock option” or “nonstatutory stock option” refers to a number of types of options to purchase company stock that, for some reason, does not satisfy the legal requirements to qualify as an ISO or a purchase plan option. Many broad-based plans (other than section 423 purchase plans) are nonqualified. A nonqualified option is the simplest of the three types of stock options (incentive stock options, section 423 plans and nonqualified stock options). A nonqualified option plan allows employees to purchase shares at a fixed exercise price for a specified number of years into the future, often subject to vesting rules.

A nonqualified stock option is generally taxed to the employee at grant only if it (the option) has a readily ascertainable fair market value at that time, which most nonqualified stock options almost never do. If it does not have such a value at grant, it is taxed at the time of exercise unless it is subject to two kinds of restrictions which are discussed under the “Tax Treatment” sub-section of the Restricted Stock section of this chapter (at page 13). The employer has a corresponding compensation deduction at the time of exercise.

Most nonqualified stock options are structured such that employees receive the right to purchase a certain number of shares of stock at a predetermined price. That option may be exercisable immediately or after the passage of a certain amount of time or upon the occurrence of a certain event.

EXAMPLE: On July 1, 1995, Corporation S grants to A, in consideration for services rendered, options to purchase 1,000 shares of S common stock. The option price is $10 per share, the stock’s fair market value at the date of grant. On July 1, 1999, when the stock’s value is $40 per share, A exercises the options in full, acquiring 1,000 shares for $10 per share. On July 1, 2000, when the stock’s value is $50 per share, A sells the 1,000 shares. Because the option did not have an ascertainable fair market value at the date of grant, there is no taxable event as a result of the grant. In 1999, when A exercises the option, he recognizes $30 per share compensation income. Under Code section 83(a), the difference between the fair market value of the stock received pursuant to the option exercise ($40 per share) and the amount paid for the stock ($10 per share) is compensation income.

Most employers using nonqualified stock options are trying to attain the same (or similar) benefits as are provided by a statutory option without the necessity of conforming to the same requirements of the Code. Using nonqualified stock options to compensate and provide an incentive for employees, the employer is able to give them a tangible reward for their efforts without using any liquid cash resources. As a result of the option, employees receive an opportunity to share in the future growth of the company.

Tax Implications Generally
The tax implications of a nonqualified stock option are governed by section 83 of the Code. Generally, Code section 83 will apply to the grant of the nonqualified option if the option itself, upon grant, has a readily ascertainable fair market value. An option to acquire nonpublicly traded stock does not have a readily ascertainable fair market value. Section 83 of the Code will apply to the exercise of a nonpublicly traded nonqualified option if the property subject to the option does not, at the time of grant, have a readily ascertainable fair market value.

As a generalization, unless a nonqualified stock option has a fair market value that can be readily determined, it will not result in a taxable transaction upon the employee’s receipt of the option.

Readily Ascertainable Fair Market Value
Generally, Code section 83(a) imposes ordinary income taxes on an employee upon the receipt of compensatory property at its fair market value. When property is received in the form of a nonqualified stock option, however, Code section 83(e)(3) requires that the option must have a readily ascertainable fair market value. If an option granted to an employee is actively traded on an established market, the option value has a readily ascertainable fair market value. Such an option would be taxable at its grant under Code section 83(a). Note that the option itself must be tradeable, not the underlying stock. Few employee options are traded on stock exchanges.

Options that are not actively traded on an established market do not have a readily ascertainable fair market value unless the fair market value “can otherwise be measured with reasonable accuracy.” The regulations create an irrebuttable presumption that an untraded option does not have a readily ascertainable fair market value unless four conditions are met, including the following:

  • The option is transferable by the optionee.
  • The option is exercisable immediately in full by the optionee.
  • Neither the option nor the underlying property is subject to any restrictions that have a significant effect on the option’s value.
  • The purchase fair market value of the option privilege is readily ascertainable. Therefore, almost all options for stock not actively traded will be deemed not to have a readily ascertainable fair market value.

Tax Implications for Employees
Publicly Traded Options A publicly traded option having a readily ascertainable fair market value will be taxed at grant. The employee will recognize ordinary income in the amount of the fair market value of the option less any amount paid for the option. Once the option’s grant is taxed, the transaction’s ordinary income consequences to the employee are closed. Thus, once the employee exercises the option, there will be no further ordinary income tax consequences.

If the stock is held as a capital asset, the employee will receive long-term capital gain treatment for the gain recognized upon its disposition. The amount of the capital gain will be measured by the difference between the selling price less any amount paid for the exercise of the option and any amount included in income upon the option’s grant.

Options Not Publicly Traded If, as is almost always the case, the option is a nonqualified stock option without a readily ascertainable fair market value at date of grant, there is no taxable event as a result of the grant. The compensatory aspects of the option remain open until the option is exercised. Once the employee exercises the option, he or she will recognize ordinary income equal to the amount of the fair market value of the stock when it is exercised minus any amount paid for the option. The effect of not having a taxable event at the time of the grant is to treat the appreciation in the value of the property as ordinary income and not as capital gain. However, if the stock is held after exercise, any additional gain is then generally treated as capital gain.

Tax Implications for Employers
The employer has a corresponding deduction (in the same amount and at the same time) as the ordinary income recognized by the employee. In general, compensation paid in the form of stock options normally triggers the receipt of wages for the purpose of employment tax and withholding provisions in the amount of the income generated under Code section 83(a).

Choosing Between Statutory and Nonstatutory (Nonqualified) Stock Options
An employer has the choice of two types of stock options that can be used to compensate employees: statutory options or nonstatutory (i.e., nonqualified) options. Any statutory stock option plan also may provide for the granting of nonstatutory options, as long as the plan does not provide for tandem options. (In the case of tandem options, two options are issued together and the exercise of one affects the exercise of the other. This is not permitted because it may evade the section 422A qualification requirements.) The differences between statutory and nonstatutory options are as follows:

  • If in the year in which gain is recognized there is little or no difference between ordinary income and capital gain marginal tax rates, one of the principal advantages (taxation at a capital gains rate) of the statutory stock option is removed.
  • The company obtains a deduction on exercise of a nonstatutory option equal to the income recognized by the employee. The company generally receives no deduction in the statutory stock option context unless there is a premature disposition by the employee.
  • The statutory option is still arguably preferable for the key employee because no income is recognized on the exercise of the option (unlike the situation with the typical nonstatutory option); income recognition of a statutory option is deferred until the employee disposes of the stock.
  • Nonstatutory options provide the employer with flexibility in plan design (because of lack of qualification rules). As a result, employers can tailor nonstatutory options to meet their particular needs. For example, nonstatutory options may be granted to non-employees, such as valued outside contractors or non-employee directors.
  • There is no requirement that the option price of a nonstatutory option be equal to the fair market value of the stock at the time of the option grant. Thus, the grantor of the nonstatutory option has complete freedom in setting the option price and the bargain purchase element.
  • Unlike statutory options, nonstatutory options can be granted pursuant to a plan that is effective for longer than 10 years, and the options can be outstanding for periods over 10 years from date of grant.
  • Nonstatutory options may be fully transferable, and there need not be any restrictions on the amount of options that can be exercised in a single year nor when the employee can dispose of the option stock after exercise.

Design Issues
Using stock option plans to create employee incentives has not escaped criticism. Some criticisms of employee options for publicly traded stock expressed in an article by Robert C. Greenberg are given below, followed in each case by a solution to the problem:

  • Options do not pay for expected performance. A company’s stock price on the market reflects the investors’ collective expectations about the company’s future performance. So long as companies perform as expected, options tend to provide the same gain no matter what the company’s actual financial results. (Options do, however, create rewards for unexpected performance.)
      Solution: Adjust the size of the option grants based on the company’s performance in excess of expectations.
  • Option gains do not parallel shareholder returns. Shareholders have invested their capital in a risky security and will not benefit until they earn an adequate rate of return on that investment as compared with the rate of the market as a whole. On the other hand, employee shareholders will benefit from any appreciation in stock price.
      Solution: Index the option’s exercise price to changes in the general level of stock prices as measured by a market index.
  • Options provide only a weak incentive because employees have limited influence on the stock price. Empirical research shows that over one-half of the variance in a company’s stock price is due to industry factors, stock market trends, and macroeconomic conditions. These conditions cannot be influenced by employee performance.
      Solution: Index the exercise price to changes in industry stock prices, using an appropriate industry index.
  • Options allow executives to select the period over which performance will be measured.
      Solution: Use options that can only be exercised at the end of their term.
  • Options are not cost-effective. Employees may discount the value of the options they receive if their portfolios are not diversified and the options are thus a riskier investment for them than for the typical stockholder. Another reason for discounting the value of an option is the risk of involuntary termination that could shorten the option’s term or make it unexercisable.
      Solution: Adjust the size of option grants to account for risk.

Restricted Stock
A simple way of providing equity incentives to employees or others is to grant stock or options and impose certain restrictions on such stock or the stock purchased pursuant to the options as a condition of such grant. Such restrictions may serve to make the stock subject to a substantial risk of forfeiture upon certain conditions and establish other restrictions upon an individual’s or entity’s ability to freely transfer the stock to other parties. If the forfeiture and nontransferability conditions are fully enforced, the grantee or optionee may not receive anything as a result of the restricted stock grant or restricted stock option.

Therefore, unlike in other stock option and grant transactions, if the risk of forfeiture is substantial, and the stock is not freely transferable, no tax is generally imposed upon the stock grant or the exercise of the option to purchase stock. It is only when the restrictions lapse at a later date that tax consequences ensue.

Stock received by employees in connection with the performance of services may be subject to certain restrictions imposed by the employer. Such restrictions might include a requirement that upon termination of employment, the employee must sell his or her stock back to the employer at a formula price based on book value. (This type of restriction is typically imposed by closely held corporations.)

Tax Treatment
The tax treatment of restricted property may be different from property that is not subject to any restrictions. The law distinguishes between two kinds of restrictions, (1) those that may lapse during the period of ownership by the employee (e.g., restrictions that lapse in 10 years if the key employee is still employed at that time); and (2) those that by their terms can never lapse. If there is a restriction that never lapses, the recipient is taxed on the date of receipt of the stock, and the restriction goes only to the extent of the value of the bargain element. If the transferred stock is both transferable and subject to a substantial risk of forfeiture, the taxable event is delayed until such restrictions lapse. The regulations define the terms for nontransferability and substantial risks of forfeiture as follows:

Substantial Risk of Forfeiture Section 83(c)(1) of the Code defines a substantial risk of forfeiture as a restriction that conditions a person’s right to full enjoyment of property upon the performance of substantial services by any individual. The regulations further provide that the services required to be performed must be substantial and that the forfeiture conditions must be likely to be enforced against the taxpayer. The regulations provide examples illustrating restrictions that would qualify as a substantial risk of forfeiture.

EXAMPLE: On November 1, 1992, X Corp. transfers 100 shares of X Corp. stock for $90 per share to E, an employee. Under the terms of the transfer, E will be subject to a binding commitment to resell the stock to X Corp. at $90 per share if he leaves the employment of X Corp. for any reason prior to the expiration of a two-year period from the date of such transfer. Because E must perform substantial services for X Corp. and will not be paid more than $90 for the stock, regardless of its value, if he fails to perform such services during such two-year period, E’s rights in the stock are subject to a substantial risk of forfeiture during such period.

EXAMPLE: On December 1, 1992, X Corp. gives to E, an employee, a bonus of 100 shares of X Corp. stock. Under the terms of the bonus agreement, if E terminates her employment for any reason, she is obligated to return the X Corp. stock to X Corp. For each year after December 1, 1992, however, for which E remains employed with X Corp., E ceases to be obligated to return 10 shares of the stock. E’s rights in 10 shares each year for 10 years cease to be subject to a substantial risk of forfeiture for each year she remains so employed.

In addition, any stock that if sold could subject a person to potential liability under 16(b) of the 1934 Act is subject to both forfeiture and nontransferability restrictions. The taxable event upon receipt of such stock would be delayed only so long as a sale of the stock would be the event that would trigger 1934 Act section 16(b) liability.

Nontransferability In addition to substantial risk of forfeiture, nontransferability is necessary to have a delay in the taxable event under Code section 83. If either of these conditions is missing, the property will be taxable at its fair market value upon receipt, regardless of the presence of other restrictions.

A restricted option (one that is subject to a substantial risk of forfeiture and is nontransferable) is taxed when restrictions lapse. Employees will recognize ordinary income in the amount of the fair market value of the stock on the date of lapse less the exercise price. Any increase in value after such taxable event will be taxed as capital gain upon disposition.

Code Section 83(b) Election
An employee receiving restricted stock may elect to have the ordinary income element of the restricted property close at the time the property is transferred. Closing the taxable event under Code section 83 gives the employee the opportunity to limit his or her ordinary income from the transaction to any spread on the date the property is transferred between the fair market value and the amount paid for the property. Any appreciation in property after the date of the transfer is potential capital gain income that will be recognized when the property is disposed of by the employee. The Code section 83(b) election must be made within 30 days after the transfer of the property; and once the election is made, it is irrevocable unless the IRS agrees to the revocation. The election is not without risk. If an employee makes the election and recognizes ordinary income and the property is thereafter forfeited pursuant to the restrictions, no deduction is available to the employee.

Stock Appreciation Rights and Stock Options
Stock appreciation rights can be used alone or in tandem with statutory or nonstatutory stock options. A stock appreciation right (SAR) is a contractual right to receive, either in cash or employer stock, the appreciation in the value of the employer’s stock over a certain period of time. An SAR gives an employee the right to obtain the future appreciation in the employer’s stock without risking any capital. In addition, an SAR used in conjunction with a statutory option or a purchase plan option enables employees to exercise options without a cash outlay.

SARs Used in Tandem with ISOs
An ISO plan may provide for tandem SARs where the exercise of one will affect the right to exercise the other as long as the SARs meet the following requirements:

  • The SAR must expire no later than the expiration of the underlying ISO.
  • The SAR may be for no more than 100% of the bargain purchase element of the underlying ISO.
  • The SAR is transferable only when the underlying ISO is transferable and subject to the same conditions.
  • The SAR may be exercised only when the underlying ISO may be exercised.
  • The SAR may be exercised only when the market price of the stock exceeds the exercise price of the ISO.

A combination of SARs and an ISO plan enables an employee to exercise an ISO without an initial cash outlay.


       On December 31, 1992, X Corp. grants to A 100 tandem ISO/SARs to either purchase one share of X Corp. stock at $10 per share (the fair market value of X Corp. stock on December 31, 1992) or receive the difference between the fair market value of a share of X Corp. stock at the time of exercise and $10. When the fair market value of X Corp. stock is $15 per share, A may exercise either his ISOs by paying the exercise price of $10 per share and receiving a share of stock worth $15 or his SARs without any current cash outlay and receive $5 in cash or other property for every SAR exercised. If A exercises 75 SARs on December 31, 1993, he will only have 25 of the original tandem ISO/SARs still available.

EXAMPLE: Assume the same facts as in the above example, but A decides that he wants to exercise enough SARs to give him cash to pay the purchase price for the remaining ISOs. A would have to exercise 66 SARs and receive $330 (66 x $5) to get enough cash to exercise the remaining 33 ISOs (33 shares x $10 exercise price). One tandem ISO/SAR remains.

Tax Implications of SARs for Employees
The taxable event for the employee is upon exercise of the SAR, not upon grant of the SAR. If an employee elects to receive the appreciation inherent in the SARs in cash, the cash is ordinary income. If the employee elects to receive the appreciation in the form of stock, the stock received is taxable to the employee under Code section 83(a) to the extent of the difference between its fair market value and the amount the employee paid for the stock; provided, however, there are no restrictions on the stock.

Tax Implications of SARs for Employers
For an employer that uses the cash method of accounting, the employer will be entitled to a deduction for SARs exercised in employer stock when that stock is transferred to the employee. A deduction for the cash method employer for payment of cash upon exercise of an SAR arises when the cash is includable in the employee’s income.

An employer using the accrual method of accounting may deduct the compensation arising from a cash exercise of SARs only when cash is includable in the employee’s income. With the accrual method, an employer may deduct the compensation generated by the exercise of SARs for stock under its regular accrual method.