The Independent Counsel

Corporate Finance

Exercise of Stock Options


Last issue, I listed some of the tax considerations affecting a company's choice of an incentive stock option ("ISO") versus nonqualified stock options to reward its employees. Companies rarely issue stock options without an eye to the eventual public sale of the stock. Therefore, here is an explanation of the effects of the SEC's rules upon stock options in the event of a public offering, plus some further tax issues.

Under changes of the SEC's short swing rules within the last decade for company stock acquired by an "insider" (e.g. by an employee upon exercise of stock options), the grant date of options, rather than their exercise date, now starts the two-year holding period under the SEC's Rule 144. This may permit the holder of a stock option to sell the shares acquired immediately upon exercise.

Unlike a nonqualified option, if shares acquired upon exercise of an ISO are then held an additional 12 months until sold, the lower long term capital gains rates will result in a tax savings to the holder of anywhere from one to 13%, depending upon the holder's individual tax profile.

While there are costs associated with deferring sale of the stock, both in the time value of money, and in the risk of a decline in market value, offering an ISO at least provides the employee with the opportunity to realize a tax saving that would not otherwise be available.

Comment: If your company can afford foregoing its compensation deduction, consider switching from a nonqualified option plan to an ISO as a tax saving to employees.

© ASSOCIATION OF INDEPENDENT GENERAL COUNSEL 1994; (all rights reserved). This article is not intended as legal advice. Consult a qualified attorney for assistance concerning a specific issue or problem.