Stock Options — The Right Carrot in Today’s Job Market?

According to the U.S. Bureau of Labor Statistics, the U.S. unemployment rate dipped to 3.5% in December, which matched a half-century low. With nationwide unemployment so minimal, your company may be struggling to fill staff positions.

Offering equity-based compensation to job candidates is one recruitment strategy to consider. Stock options have proved to be an effective tool for attracting executives and other employees, as well as retaining and motivating them.

Getting a handle on ISOs

Stock options confer the right to buy a certain number of shares at a fixed price for a specified time. Typically, they’re subject to a vesting schedule. This requires recipients to stay with the company for a certain amount of time or meet certain performance goals.

Incentive stock options (ISOs) offer attractive tax advantages for employees. Unlike nonqualified stock options (NQSOs), ISOs don’t generate taxable compensation when they’re exercised; the employee isn’t taxed until the shares are sold. And if the sale is a “qualifying disposition,” 100% of the stock’s appreciation is treated as capital gain and is free from payroll taxes.

To qualify, the ISOs must meet certain requirements:

  • They must be granted under a written plan that’s approved by the shareholders within one year before or after adoption.
  • The exercise price must be at least the stock’s fair market value (FMV) on the grant date (110% of FMV for more-than-10% shareholders).
  • The term can’t exceed 10 years (five years for more-than-10% shareholders).

Additionally, the options can’t be granted to nonemployees; employees can’t sell the shares sooner than one year after the options are exercised or two years after they’re granted; and the total FMV of stock options that first become exercisable by an employee in a calendar year can’t exceed $100,000.

Identifying the downside of ISOs

ISOs also have drawbacks. Unlike NQSOs, qualifying ISOs don’t generate tax deductions for the employer. Plus, with ISOs there is a potential AMT issue upon exercise.

What about nonqualified stock options?

NQSOs are simply stock options that don’t qualify as ISOs. Typically, the exercise price is at least the stock’s FMV on the grant date (to avoid tax complications that won’t be discussed here). Generally, the NQSO itself isn’t considered taxable compensation; there’s no taxable event until exercise. At that time, the spread between the stock’s FMV and the exercise price is treated as compensation.

Even though NQSOs are taxed as ordinary income upon exercise, they have several advantages over ISOs. For one thing, they’re not subject to the ISO requirements listed above, so they’re more flexible. For example, they can be granted to independent contractors, outside directors or other nonemployees. Plus, they generate tax deductions for the employer and don’t expose recipients to AMT risks.

And then there’s restricted stock

Another choice is to grant employees restricted stock — nontransferable stock that’s subject to forfeiture until it vests (based on performance, years of service, or both). Restricted stock generally will retain at least some value even in volatile times, unlike options, which may become worthless if the stock’s price declines below the exercise price.

Generally, the FMV of restricted stock is taxable to the employee (as ordinary income) and deductible by the employer when it vests. However, the employee can potentially reduce the tax by filing an “83(b)” election to pay tax when the stock is received, converting all future appreciation to capital gains upon sale of the stock. But this strategy can be risky: If the stock is forfeited, the employee will have paid tax on income that is never received.

Seek advice

If you’re considering an equity-based compensation plan, it’s important to review the pros, cons and tax implications of various approaches. Talk with one of our tax professionals on  (973) 298-8500 or about whether ISOs are right for your company.

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