Corporate Finance

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Qualified vs. Nonqualified Stock Options

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BY WILLIAM F. SWIGGART

Fast growing technology companies depend on stock options to compensate employees and encourage further strenuous growth, as illustrated by the reportedly intense opposition among Massachusetts and California technology companies to the FASB's pending proposal to charge stock options against corporate earnings.

While there wasn't much tax difference between an option under a tax qualified Incentive Stock Option Plan (an "ISOP"), and a nonqualified stock option until recently, the Clinton tax bill's top rate of 36% on ordinary income reintroduced a significant benefit for capital gains income, which remains taxable at only 28%.

Since an ISOP produces capital gains income, it seems timely to review the differences between ISOPs and nonqualified options:

Incentive Stock Options:

• May be issued only to an employee;
• Must have an exercise price at least equal to the fair market value ("FMV") at time of grant;
• Must be nontransferable, and exercisable no more than 10 years from grant;
• For 10%+ stockholders, exercise price must equal 110% or more of FMV at time of grant; and
• Exercise cannot, as determined at the time of the grant, yield stock valued at more than $100,000.
• Tax Consequences:
  
  
  • To Employee. No tax at the time of grant or at exercise. Capital gain (or loss) tax only upon sale of stock if employee holds stock acquired by exercise a year or more from exercise and at least two years from grant.
    
    
  • To Company. No deduction generally.

Nonqualified Stock Options:

• Issuable to anyone (e.g., employee, outside director or other service provider);
• May have any exercise price;
• May be transferable or not;
• No limit on the value of stock that can be received as a result of exercise;
• Tax Consequences:
  
  
  • To Recipient. The recipient receives ordinary income (or loss) upon exercise equal to the difference between the exercise price and the FMV of the stock at date of exercise.
    
    
  • To Company. Company receives deduction in year recipient recognizes income provided, in the case of an employee, that company satisfies withholding obligations.

Comment: Stock options, whether qualified or not, remain an attractive means of compensating and motivating employees and service providers in lieu of cash.