TOPIC 36: EMPLOYEE STOCK OPTIONS in .NET framework

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TOPIC 36: EMPLOYEE STOCK OPTIONS
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1 Basic provisions A Company restrictions Insiders are subject to insider trading rules that limit the sale of stocks by the employee to within six months of the time he or she has been issued the option B Transferability (1) Incentive stock option (ISO) Only the employee may exercise the option during his or her lifetime The employee can transfer only upon death (2) Nonquali ed stock option (NSO) Option is transferable to family members C Retirement (1) Systematic repositioning of the portfolio is a consideration if the stock represents a large percentage of the employee s holdings (2) A method must be devised to raise cash for exercising the options if the employee wants potential future appreciation D Vesting schedule (1) Straight vesting Same percentage of options becomes exercisable each year (eg, 500 options each year)
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112 - Employee Bene ts Planning (2) Cliff vesting All options become exercisable at one time (3) Step vesting The percentage of exercisable options varies year to year (4) Performance vesting Options become vested in the year the company achieves a particular goal (eg, revenue or price/share goal) (5) Early vesting (accelerated exercise) In this type of arrangement, employees are allowed to immediately exercise options when they are granted For each option exercise, they receive a share of restricted stock, which is subject to a holding period that is based on the stock option plan s original vesting schedule E Expiration (1) Generally, employees have 10 years (or less) to exercise the option (2) Terminated employees may have 30 to 90 days after termination to exercise vested options; the period may extend to six months to one year in the event of death or disability F Availability to nonemployees (directors, board members, etc) An individual must be an employee to bene t from an ISO G Cashless exercise/same day sale No money is exchanged A broker lends money to the employee to purchase shares and then sells them immediately for a fee H Potential problems include expiration of the option, termination from employment, and overallocation 2 Incentive stock options (ISO) A Income tax implications (regular, AMT, basis) (1) Upon grant Income not reported; no income tax due (2) Upon exercise No income for calculating regular tax Difference between the fair market value (FMV) at exercise and exercise price (the bargain element or spread ) is an adjustment item for calculating the alternative minimum tax (AMT) (3) Upon (qualifying) sale For AMT, long-term capital gain is difference between FMV at time of sale and FMV at time of exercise For regular tax, long-term capital gain is difference between FMV at time of sale and exercise price (4) Employer receives no tax deduction, unless holding requirement is not satis ed B Holding period requirements for a qualifying sale Shares must be held for at least one year after the option is exercised and for at least two years after the option is granted (1) If the holding period requirement is not met, a disqualifying disposition occurs and the appreciation on the sale (untaxed bargain element plus other appreciation) will be taxed as ordinary income (2) An employee receiving the ISO is required to continue as an employee from the time of the grant of the options until at least three months before the exercise If not, options are converted to NSOs C Disqualifying dispositions If the holding requirements are not satis ed, then a portion of the employee s pro t is taxed as compensation and the employer is allowed a deduction for that compensation The other portion is taxed to the optionee as a short-term capital gain D Employee bene t analysis and application Options may be granted to executives, key employees, or other groups of employees on a discriminatory basis 3 Nonquali ed stock options (NSO) A Income tax implications (regular, AMT, basis) (1) Upon grant No income tax is due
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Topic 37: Stock Plans - 113 (2) Upon exercise The employee realizes income equal to the difference between grant (exercise) price and FMV at time of exercise This difference is called the bargain element The FMV at time of exercise becomes the new cost basis The company must withhold federal and state taxes (using the supplemental wage tax 27 percent federal rate until it drops in 2004) as well as Social Security taxes Depending on the individual s tax situation, too much or too little tax may have been withheld (3) Upon sale If the employee holds the stock and sells later, the employee recognizes capital gain or loss; may be short or long term, depending on whether it is held for more than one year The sale will not trigger additional tax unless the selling price exceeds the share basis B Gifting opportunities may gift to family members, family trusts, charities (1) IRS safe harbor allows the gifting of vested options where valuation is based only on Black-Scholes valuation model (2) Gift tax valuation Options must be valued for gift tax purposes at the time of the gift If the employer uses straight vesting (eg, 20 percent yearly for ve years), the employee can make a completed gift of the vested portions at an earlier date when the options have a low value C Employee bene t analysis and application Option may be granted to an employee, a member of the board, an independent contractor, a family member, or any other bene ciary of the employee on a discriminatory basis 4 Planning strategies for employees with both incentive stock options and nonquali ed stock options A There should be consideration given to exercising options and selling stock over a period of time to take advantage of price averages and risk reduction B Individuals in high tax brackets should consider early exercise for appreciating stocks to bene t from lower taxes, because the bargaining element is taxed as income for NSOs and possible AMT consequences for ISOs C It makes sense to hold on to the stock for more than one year after exercise to change tax treatment to long-term capital gain D Diversi cation and meeting nancial goals may be good reasons for selling options sooner than the end of the exercise period 5 Election to include in gross income in the year of transfer (Section 83(b) election) A Employee makes an election to include in income the FMV of the stock, less any amount paid for the stock, at the time the stock is issued B The election can be made only if the stock is subject to substantial risk of forfeiture and is not transferable C After the forfeiture restrictions have lapsed, any subsequent appreciation or depreciation after the election date is taxed as capital gain or loss when the employee sells the stock
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