Whether the employee is taxed upon receipt of the option or upon exercise of the option depends upon whether the option has a readily ascertainable fair market value at the time the option is granted.
If it is determined that the option has a readily ascertainable fair market value when it is granted, the employee will realize income at the time of the grant to the extent of the difference between the option's fair market value and the employee's cost. Normally, the employee will have paid nothing for the option, and the option's value will be the discount amount at which the stock can be purchased. This discount amount will be taxable to the employee and deductible by the employer.
If it is determined that the option has no readily ascertainable market value, the grant of the option is not the taxable event. Instead, the exercise of the option will be taxable if the employee's interest in the stock acquired through the option is not subject to a substantial risk or forfeiture. If it is subject to substantial risk or forfeiture, taxation will be further postponed until the employee's interest in the stock is no longer subject to such risk or forfeiture.
In order to establish whether there is a readily ascertainable market value, the IRS requires that the option either be publicly traded or:
"Privelege" means the opportunity to benefit, at any time during the period in which the option may be exercised, from any appreciation in value of the option that occurs during such period and does not involve the risk of any capital.
Stock Appreciation Rights & Phantom Stock Plans:
Like stock option plans, these two plans give an employee an incentive in a corporation measured by the performance of it's stock. Both plans allow an employee to receive cash in the form of compensation if the value of the company's stock rises in a fixed period of time. Such compensation is not taxed until received by the employee and not deductible until paid by the corporation.
A Stock Appreciation Right is the right to receive compensation based upon the amount a corporation's stock increases over a fixed period of time. The employee has the right to receive in cash the amount equal to the value of appreciation in the corporation's stock.
Under a Phantom Stock Arrangement, the employee receive a hypothetical number of shares of the corporation's stock based upon either the fair market value or the book value of such shares. No actual shares are issued or set aside. The Phantom Stock Account may also be credited with dividends paid by the corporation. Normally, at the end of a specified period of time, the Phantom Stock Account can be converted to cash, stock or a combination of both.