Currently, the Code recognizes three basic arrangements whereby a corporate employer may provide financial interest to its employees to buy company stock:
1. Incentive Stock Options (ISOs). An ISO is usually aimed at giving key employees an opportunity to acquire stock at a "bargain price"without incurring any tax liability until the shares are sold. The employee is not taxed when the option is granted or when it is exercised. If holding period requirements are met, the participating employee is taxed at the capital gains rate on any realized gain. Generally, the employee must hold the stock for at least one year after after it has been transferred to him and he must not sell or dispose of the stock received under an option within two years after the option is granted. He must be an employee from the date of the granting of the option until a date three months before the date of exercise (except for a disabled employee who may exercise an option within twelve months of leaving employment.)
2. Employee Stock Purchase Plans. An employee stock purchase plan is similar to an ISO in that employees are given an option to buy the employer's shares at a price that may be below market when the option is exercised. These types of plans are different from ISOs in that they may not discriminate among employees and are there aimed primarily at rank and file employees.
3. Employee Stock Ownership Plans (ESOPs). ESOPs are a type of qualified plan that generally take the form of a stock bonus and/or money purchase plan. The plans are designed to invest in employer securities and may borrow funds to purchase the securities.
The term "incentive stock option" means an option granted by a corporation to an employee. A stock option is an agreement on the part of a corporation to sell a given number of shares of its stock at a given price (the option price) to an employee within a specified period of time. In most cases, the decision to exercise the option and buy the shares is left entirely to the employee.
A transfer of stock pursuant to an incentive stock option is not a taxable event. Thus, no income is received by an employee when the employee exercises the option and receives the stock. Also, when stock is transferred pursuant to an option, the employer corporation may not take a business deduction with respect to such transfer, and no amount other than the price paid under the option may be considered as received by the corporation for the stock transferred. The favorable tax treatment of incentive stock options does not apply for AMT purposes to options exercised after 1987. A employee must include in income the amount by which the option price is exceeded by the stock's fair market value at the time the employee's rights to the stock are freely transferable or are not subject to a substantial risk of forfeiture. If stock acquired under a statutory option is used to acquire stock in connection with the exercise of an incentive stock option and the transferred stock has not met minimum holding period requirements, ordinary income may be recognized. However, the acquired incentive stock still qualifies for favorable tax treatment.
Generally, the incentive stock option must be granted pursuant to a plan that details the aggregate number of shares that can be issued under the options and details the number or class of employees that may receive them. The plan must be approved by the corporation's stockholders within 12 months before or after it is adopted. Also, an option must be granted within (4) years after the plan is adopted or within 10 years after the plan is approved by the shareholders, whichever is the earlier. The approval of stockholders must meet the requirements of the corporate charter, bylaws, and state law setting forth the method and:degree of stockholder approval required for the issuance of corporate stock or options.
An individual who receives a stock option grant cannot (at the time the option is offered) own stock possessing more than 10 percent of the total combined voting power of all classes of stock of the employer corporation or of its parent or subsidiary corporations. However, this so-called "10 percent shareholder rule" does not apply if the option price, at the time the option is granted, is at least 110 percent of the fair market value of the stock covered by the option and the option cannot be exercised more than five years after it is granted. Options will not be treated as incentive stock options to the extent that the aggregate fair market value of stock with respect to which options meeting the Code Sec. 422(b) requirements are exercisable for the first time by any individual during any calendar.year (under all plans of the individual's employer corporation and its parent and subsidiary corporations) exceeds $100,000. For purposes of this rule, fair market value is determined at the time the option is granted. This $100,000 rule is applied by taking into account in the order in which they are granted options that meet the Code Sec. 422(b) requirements and are exercisable for the first time in the calendar year. An option is not treated as an incentive stock option if, at the time it is granted, the terms of the option provide that it will not be treated as an incentive stock option. .
Option Price
The option price offered the employee by the corporation must not be less than the fair market value of the stock at the time the option is granted. However, a good faith attempt to value the stock accurately, even if the option price is later found to be less: than the value of the stock, will not prevent an option from being considered an incentive stock Option. In order to ensure that the fair market requirements are not avoided, the Code requires that the fair market value of stock is to be determined without regard to any restriction other than a restriction that, by its terms, will never lapse.
Exercise
An incentive stock option by its terms must be exercised within 10 years after the date the option is granted. An option cannot be transferred by the individual receiving the option except by will and the laws of descent and distribution; and it is exercisable during his lifetime only by him. An employee may pay for the stock obtained pursuant to an option with stock of the corporation granting the option and still receive incentive stock option tax treatment. An employee can also receive property at the time he exercises the option without preventing the option from being considered an incentive stock option.
Holding Period
In order for a stock option to be considered an incentive stock option and receive special tax treatment, an employee:
1. must not sell or dispose of stock received under an option within two years after the option is granted, and
2. must hold the shares of stock for at least one year after they have been transferred to him. In addition, the option holder must be an employee of the company granting the option (or its subsidiary, parent, etc.) for the entire time from the date the option is granted until three months before the date of the exercise. If he becomes disabled, the aforementioned three month period before the date of the exercise becomes one year. Holding requirements and the employee status requirements are waived in the event of the employee's death.
Taxation
Upon the disposition of stock held pursuant to the exercise of an incentive stock option, any gain recognized is subject to capital gains treatment and the employer-corporation receives no business deduction. However, if all of the requirements necessary for incentive stock option treatment are met, except the holding period requirements, tax is imposed on the sale of the stock and the gain is treated as ordinary income. Gain for this purpose is equal to the lesser of (1) the fair market value of the stock on the date of exercise over the option price of the stock or (2) the amount realized on disposition over adjusted basis of the stock. In this instance, the employer granting the option receives a business expense deduction.
Transfers by Insolvents
When an insolvent individual holds stock acquired pursuant to the exercise of an incentive stock option, any transfer of the stock to a trustee, receiver; or fiduciary as part of any insolvency proceeding does not constitute a valid disposition of the stock as far as the incentive stock option holding rules are concerned. Thus, there is no violation of the requirement that shares must be held for two years from the date an option is granted and held for one year after the actual transfer of stock to the employee in order to receive incentive stock option tax treatment.
Employee's Death
The rules apply to exercise of an option by an employee's estate or any person who acquired the option by bequest or inheritance or by reason of the death of such individual, to the same extent as if the option had been exercised by the deceased employee. However, the holding period and the employment requirements applicable to the optionee employee are not carried over to the estate or beneficiary. When, however, capital gain is involved, the estate or beneficiary is still bound by the provisions of the Code on a short-term and long-term capital gain or loss. If an employee dies without having exercised an option under an employee stock purchase plan or under an incentive stock option plan, but the option can be and is exercised by his estate or beneficiary, then the estate (or beneficiary) must include, as compensation in its gross income for the taxable year in which the stock is sold or disposed of, an amount equal to the difference between the option price and the lesser of (1) the fair market value of the share at the time of disposition, or (2) the fair market value of the Share at the time the Option was granted. When the estate transfers stock acquired pursuant to the exercise of an option under an employee stock purchase plan or an incentive stock option plan to any beneficiary of the estate, such transfer is treated as a "disposition" of the stock. For the purpose of computing gain or loss on the disposition of shares of stock acquired by an estate or bene~ciary under a stock option issued to an employee, the value of the option at date of death (or the alternate estate tax valuation date) is added to the option price to determine its basis to the estate or beneficiary. This tentative basis must be adjusted downward if (and to the extent that) the amount treated as ordinary income is less than the amount that would have been so treated if the employee had exercised the option and held the stock at the date of his death. Also, the rule that requires the amount treated, as ordinary income be added to the basis of the stock applies only if, and to the extent that, this amount-exceeds the value of the option for estate tax purposes.
Exercise
Employee Stock Purchase Plans. Options issued under an employee stock purchase plan are a type of employee stock option for which special tax treatment is allowed. If the plan is qualified, the employee receiving an option to purchase the stock of the employer will not be taxed until the stock acquired under the option is: sold or exchanged. In order to be qualified, a plan must include all employees except those specifically excluded, such as part-time, seasonal, or highly compensated employees. A plan will not be denied qualification solely because eligible employees who elect not to participate in an option offering are not granted options under the offering.
Tax Treatment
If stock acquired under an employee stock purchase plan is disposed of after being held for the required period, the tax effects depend upon the option price. In the case of employee stock purchase plans; the option price can be as low as 85 percent of the market value of the stock at the time the option is granted or at the time the option is exercised. If such a discount was given, the employee will realize ordinary income when he exchanges, sells, or otherwise disposes of the stock to the extent of the excess of the fair market value of the stock at the time the option was granted over the option price. If the option price is not fixed or determinable at the time of grant --that is, if it is expressed as a percentage of value at date of exercise --the option price is determined as if the option were exercised at such time. Any further gain is taxed at capital gain rates. To obtain this maximum tax benefit, at least two years must elapse from the time the stock option is granted to the employee, and he must hold the shares for the long-term capital gain holding period, more than one year.
Example 1:
An employee is given an option under an employee stock purchase plan to purchase stock for$75 at a time.when the stock is worth $100. He exercises the option after two years, and, more than one year later, sells the stock for $150. The excess of the fair market value of the stock at the time the option was granted over the option price ($25) is ordinary income. The remaining $50 is capital gain.
If the stock is disposed of when its value is less than its value at the time the option was granted, the amount of ordinary income will be limited to the excess of present value over the option price. Thus, if the stock in the preceding example had been sold for $95, there would be $20 of ordinary income and no capital gain. Additional ordinary income is realized, however, where the stock is sold before it has been held for the long term capital gain holding period, and the combined holding period of the option and the stock is less than two years. The amount to be treated as ordinary income is the difference between the option price and the price of the stock at the time the option is exercised.
Example 2:
Assume that the employee in Example (1) exercises his option at a time when the value of the stock is $115. Also assume that he exercises the option and sells the stock before the expiration of 2 years after the Option is granted. He then has $40 ordinary income:($115 - $75) and capital gain of $35.
Although the selling price may be less than the value of the stock at the time of exercise, the same amount of ordinary income is realized and a capital loss is recognized equal to the difference between the value of the stock at the time of exercise and the selling price.
Example 3:
Assume the same facts as in Example (2), except that the selling price is $95 per share. The employee has ordinary income of $40 ($115 - $75) and a capital loss of:$20 ($115 -·95).
Beginning with the date of the granting of the option and ending on the day three months before it is exercised, the individual must be an employee either of the corporation granting the option, a parent or subsidiary of such corporation, or a corporation (or parent or subsidiary of such corporation) issuing or assuming a stock option in a corporate reorganization or liquidation.
Requirements
An employee stock purchase plan is, generally, one permitting employees to buy stock in the employer corporation at a discount. The plan must provide that only employees may be granted options and must be approved by the stockholders of the granting Corporation within 12 months before or after the date the plan is adopted. Other conditions that must be met either by the plan or in the stock offering are:
1. The option price may not be less than the smaller of (a) 85 percent of the market value when the options granted or (b) 85 percent of the value at exercise.
2. The option must be exercisable within five years from the date of grant where the option price is not less than 85 percent of the fair market value of the stock at exercise. If the option price is less, then the option must be exercisable within 27 months of the date of grant. If a plan provides for the purchase of shares by accumulated payroll deductions, the date of grant of an option under the plan is the first date of the purchase period if the maximum number of shares is fixed and determinable on that date.
3. The plan must be nondiscriminatory in that options must be granted to all employees except that part-time employees (20 hours or less-weekly or less than five months a year), employees with less than two year' service, and officers, supervisors, and highly compensated employees within the meaning of Code Sec. 414(q) may be excluded from the plan.
4. All employees granted options must have the same rights and privileges except that the amount of stock that may be purchased by any employee may be a uniform percentage of compensation and the plan may limit the maximum number of shares to be purchased by any one employee.
5. No options may be granted to owners of five percent or more of the value or voting power of all classes of stock of the employer or its parent or subsidiary.
6. An employee may not purchase more than $25,000 of stock (based upon the fair market value at the time the option:was granted) in one year, unless he purchased less than $25,000 of stock in an earlier year when the option was in effect.
7. The option may not be transferable: (other than by will,or laws of inheritance) and may be exercisable only by the employee to whom it is granted.
A stock: purchase plan under which the maximum percentage of compensation an eligible employee may allocate to the purchase of stock is based on both total compensation and seniority does not qualify as an employee stock purchase:plan.
Employee Stock Ownership Plans (ESOPs)
An ESOP is a qualified stock bonus plan or a qualified stock bonus and a money purchase plan, which are designed to invest primarily in qualifying employer securities.
Basically, an employee stock ownership plan is a stock bonus plan, although it may be coupled with a money purchase plan. However, the distinction that is drawn between a stock bonus plan and an ESOP is that the ESOP is used as a financing vehicle for the employer corporation.
How an employer can use an ESOP as a financing vehicle is apparent from looking at the typical ESOP setup:
1. The ESOP borrows money to purchase the employer's stock. The money is usually borrowed from a commercial lender. There is a lender investment exclusion, (which is a special incentive to lenders to loan money to an ESOP.) The loan is secured by the stock and is usually guaranteed by the employer-corporation.
2. The loan proceeds are paid to the employer (or other shareholders) for the stock in the employer-corporation.
3. The ESOP repays the loan in cash that is contributed to the ESOP by the employer.
4. The employer contributions to the ESOP are fully:deductible as qualified plan contributions.
An ESOP provides the following advantages:
1. Increase in cash flow. The employer can provide benefits for employees without a cash-outlay. If contributions are made directly in stock, the fair market value of that stock is deductible, but there is no cash outlay. If there is large initial borrowing, to be repaid with contributions over the years, the cash position is immediately improved.
2. Facilitation of growth. The employer is not deprived of needed working capital by large cash contributions to plans.
3. Employee incentive. If employees feel that their efforts are directly:related not only to what goes into the plan but also to the growth of the stock in the plan, the incentive value may be increased.
4. Market for minority interests. The plan can create a ready market for minority interests, including those of retiring employees who will ordinarily wish to convert their stock into cash. It:can also solve the post-death liquidity problems of substantial stockholders.
5. Appreciation on employer securities. Whereas capital gain treatment for lump-sum distributions from qualified plans is currently being phased out (treatment of capital gains applies only to that part of the distributions attributable to plan participation before 1974), this rule does not apply to appreciation on employer securities which are distributed. This appreciation will continue-to be taxed as a capital gain, and, then, only when the employee actually sells the securities.