Stock Options
Chapter 35
Employee Benefit & Retirement Planning
What is it?
A formal, written offer to sell stock at a specified price,
within specified time limits
– granted as additional compensation with expectation stock
value will rise
– gives executives advantages of business ownership
Two types of stock options are typically used to
compensate executives:
– incentive stock option plans (ISOs)
– nonstatutory stock options
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Stock Options
Chapter 35
Employee Benefit & Retirement Planning
What is it?
Desirable because
– expect stock value will rise, allowing gain on spread between
option and market price
– can defer tax to when stock purchased
– gives executives ownership in the business
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Stock Options
Chapter 35
Employee Benefit & Retirement Planning
When is it Indicated?
1.
2.
Employer willing to share business ownership
Employer wants to reward executive performance
with compensation that increases in value as the
employer stock increases in value
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Stock Options
Chapter 35
Employee Benefit & Retirement Planning
Advantages
1. Flexible plan design and few tax or governmental
regulatory constraints
2. Little to no out-of-pocket cost for company
3. Employee can defer tax until exercise option or later
if combine option with nonqualified deferred
compensation arrangement
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Stock Options
Chapter 35
Employee Benefit & Retirement Planning
Disadvantages
1. Executive bears market risk on stock option
2. Executive must have source of funds for stock
purchase
3. Market price of stock may have little relationship to
executive performance
4. Employer tax deduction usually delayed until
executive exercises stock option
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Stock Options
Chapter 35
Employee Benefit & Retirement Planning
Tax Implications
Option has no readily ascertainable fair
market value at time granted:
1. Executive has no taxable income at date of grant
2. When shares purchased, the ‘bargain element’ is treated
as ordinary income and taxed accordingly
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Stock Options
Chapter 35
Employee Benefit & Retirement Planning
Tax Implications
Option has no readily ascertainable fair
market value at time granted:
3. Employer’s tax deduction taken when option exercised
and is equivalent to employee taxable income from the
exercise of the option
4. Executive’s basis in the shares = amount paid for the stock
+ amount of taxable income reported by the executive
when option exercised
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Stock Options
Chapter 35
Employee Benefit & Retirement Planning
Tax Implications
Option has readily ascertainable fair market value
– Employee Taxed at time of grant
– Employer received at time of grant
– Employee has no further taxable compensation income
when option later exercised
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Stock Options
Chapter 35
Employee Benefit & Retirement Planning
True or False?
1. Stock options are often used by closely held
corporations as a way to reward executives.
2. Stock options are a form of compensation with little
to no out-of-pocket costs to the company
3. The company bears investment risk when granting
a stock option to an executive.
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Stock Options
Chapter 35
Employee Benefit & Retirement Planning
True or False?
4. Tax laws are the same whether or not company
stock has a readily ascertainable fair market value at
the time that it is granted.
5. An option has readily ascertainable fair market value
if it has a value that can be determined as of time of
the grant and the option can be traded on an
established market.
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Stock Options
Chapter 35
Employee Benefit & Retirement Planning
Discussion Question
What is the effect of federal securities laws on stock
option plans?
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