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Rule 144 and Restricted Stock

What a Good Buy-Sell Agreement Can Do for You

The 83(b) Election and Your Start-Up’s Compensation Program

A Beginner’s Guide to Stock Options and Their Alternatives

A Comparison of the Limited Liability Company and the S-Corporation

A Beginner's Guide to Stock Options and Their Alternatives

By Julia K. O'Neill

A stock option is a right granted by a corporation to a person that gives that person the right to purchase stock in the corporation under specified conditions and at a specified price. Many companies institute stock option plans for the benefit of their employees in order to create an ownership mentality and related incentive for better productivity and the like. This article is an introduction to the different types of options and their alternatives. It does not address securities laws issues.

Note that issuing stock subject to buy-back restrictions that lapse over time is, in many cases, preferable to either type of stock options. See "Restricted Stock," below.

There are two types of stock options used for employee compensation: Incentive Stock Options ("ISO's") and Non-Qualified Options (also called "Nonstatutory Options"). The differences between the two should be thoroughly examined by any corporation and its counsel before putting an option plan into place or granting any options.

ISO's and Non-Qualified Options have differing tax consequences, to both the employer and the employee. Generally, the employee who receives an ISO does not realize taxable income at the time of grant or at the time of exercise. Instead, in general, the employee is taxed at the time of disposition of the underlying stock. The gain may constitute capital gain, rather than ordinary income, if the employee has held the underlying stock until the later of two dates: the date that is two years after the grant date, and the date that is one year after the exercise date. If the holding period is not met, the disposition is called a "disqualifying disposition." In that event, a portion of the income (the amount by which the stock’s fair market value on exercise of the option exceeds the option price: the "spread") will be taxed at ordinary income rates and a portion (any excess over the first amount) at capital gain rates. (There is rarely any portion exceeding the first amount, so usually all of the income is ordinary income upon a disqualifying disposition.)

Many ISO's end up losing their capital gain treatment in practice, because at the time of an initial public offering, merger, sale or other major corporate transaction resulting in liquidity of the corporation’s stock, option holders will choose to exercise their options and simultaneously sell the underlying stock, thus receiving ordinary income treatment on the "spread." Even so, ISO's are an attractive choice because they do allow for the possibility of capital gains treatment.

There are Alternative Minimum Tax ("AMT") considerations which must be examined at the time of exercise of an ISO and time of disposition of the underlying stock, which may change the general treatment described above. For AMT purposes, the excess of the fair market value of the stock as of the date of exercise, over the exercise price of the ISO, is included in computing that year's alternative minimum taxable income. However, if the shares are disposed of in the same year, the maximum AMT taxable income with respect to those shares is the gain on disposition. There is no AMT income from a disqualifying disposition (one not meeting the holding period described above) in subsequent years.

Generally the employer does not get a deduction for compensation expense with regard to the granting of ISO's. However, at the time of a disqualifying disposition by an optionee, the employer will be entitled to a deduction for the amount received by the optionee to the extent that such amount is taxable to the optionee as ordinary income.

Non-Qualified Options differ from ISO's for tax purposes in several ways. One is that they are taxed to the employee as income at the time of grant or exercise. If the options have a readily ascertainable fair market value (which most don't, according to the Internal Revenue Code, unless they are publicly traded), they will be taxed to the employee at grant. Otherwise, generally, assuming compliance with the provisions of Internal Revenue Code Section 409A (see next paragraph), the employee will have taxable income at the time of exercise of the options to the extent of the difference between the fair market value of the underlying stock, and the exercise price. The employer has a corresponding deduction for compensation at the time of exercise.

Recent changes to the Internal Revenue Code have significantly changed practices with respect to Non-Qualified Options ("NQSO's"). Previously, employers often issued NQSO's with low exercise prices, often far below the fair market value of the underlying stock. Code Section 409A now makes such a practice highly undesirable. Section 409A effectively requires that the exercise price of NQSO's be at least equal to the fair market value of the underlying stock; otherwise, severe tax penalties may be suffered on the part of the employee. The regulations under Section 409A provide guidelines as to how a company should determine the fair market value of its stock for these purposes. See "Valuation," below.

If the stock purchased through exercise of Non-Qualified Options is subject to restrictions which lapse with the passage of time (such as buy-back rights of the employer if the employee leaves the company; not a very common circumstance, since vesting can be built into the options themselves), the income event will be postponed until the restrictions lapse, unless the employee makes an "83b election," opting to take the income into account at the time of exercise. The employee would make this election in order to take income into account when the value of the underlying stock is presumably lower than it would be later, when the restrictions lapse. However, the employee risks losing the stock altogether in the event of forfeiture (due to termination of employment or otherwise, in accordance with the restrictions), and will have already paid taxes on the income recognized under the 83b election. The employee will not be entitled to take any loss for the taxes already paid.

A stockholder will recognize gain or loss on the subsequent sale of stock acquired upon exercise of Non-Qualified Options in an amount equal to the difference between the selling price and the tax basis of the stock, which will include the price paid plus the amount included in the holder's income by reason of the exercise of the Non-Qualified Options. Provided the shares of stock are held as a capital asset, any gain or loss resulting from a subsequent sale will be capital gain.

In order to be treated as ISO's, options must meet various requirements of the Internal Revenue Code, including, among other things, that: (i) the exercise price must be at least current fair market value of the stock; (ii) the options can be granted only pursuant to a written plan which has been adopted by the shareholders and which includes the aggregate number of shares available pursuant to the plan and the employees or class of employees eligible pursuant to the plan; (iii) the exercise period cannot be longer than 10 years; (iv) if the employee owns more than 10% of the voting power of all stock outstanding, his exercise price must be at least 110% of current fair market value, and his exercise period cannot be longer than 5 years; (v) the options are not transferable and can be exercised only by the employee during his lifetime; and (vi) at all times during the period beginning on the date of the granting of the option and ending on the day 3 months before the date of such exercise, the individual must be an employee of either the corporation or a parent or subsidiary corporation. To the extent that the aggregate fair market value of stock with respect to which incentive stock options are exercisable for the first time by any individual during any calendar year exceeds $100,000, those options will not be treated as incentive stock options.

Non-Qualified Options have no such requirements. The price and exercise period can be at whatever the Board determines, subject, however, to the provisions of Section 409A of the Internal Revenue Code, mentioned above, and the penalties provided therein; the options can be granted by the Board without shareholder approval of a formal plan; and so on.

Both types of options are popular. The tax treatment of the ISO is more attractive to the employee, because the tax event occurs when the employee has cash (from the underlying sale of the stock) to pay the tax, and it will generally be at capital gains rates.

The choice between the two types of options should be made in the context of examining which of the factors described above are most important to the persons and the entity involved. If the most important aspect is letting the employees get capital gain treatment (or at least have the possibility of doing so), and shareholder approval of the plan (and most amendments) is not an obstacle, then ISO's are the way to go. The company can, of course, grant non-qualifieds to some people and ISO's to others.


Code Section 409A and the regulations thereunder provide guidelines for how a company should go about valuing its stock for purposes of determining exercise prices for options. Section 409A provides that a value will be presumed to be fair market value in certain circumstances.

In the case of a publicly-held company whose stock is traded on an established securities market, fair market value is determined with reference to the market price of the shares.

With respect to non-public companies, to qualify for the presumptions on fair market value, a value for common stock must be determined by "a reasonable application of a reasonable valuation method." Essentially, this is a facts and circumstances test, although the regulations provide that a valuation method will be presumed reasonable if either of the following two methods is consistently applied to compensatory equity awards:

A valuation by an outside independent appraiser meeting requirements comparable to valuations for charitable donations that is performed within 12 months of the grant date (unless intervening events have triggered a change in value, in which case a new valuation should be obtained). This article refers to this valuation method as an "Independent Appraisal."

A reasonable good-faith valuation of "illiquid stock of a start-up corporation" that is supported by a written report taking into account certain standard valuation factors (asset value, present value of future cash flow, market value of similar companies, and other relevant factors). The persons performing these valuations must have "significant knowledge and experience or training in performing similar valuations." The report must be in writing. There are other limitations in utilizing this method, including that the company may not have been in trade or business for 10 years or more and the company does not reasonably expect that it will undergo a change in control or public offering of securities within 12 months. This article refers to this valuation method as an "Internal Valuation Report."

Either an Independent Appraisal or an Internal Valuation Report should be obtained or provided to the Board of Directors at the time of grant of stock options. Such reports should be updated at least annually, depending upon the frequency of equity grants and depending upon internal or external events which could affect the value of a company’s common stock. For privately-held corporations, the fair market value of stock as of a valuation date means a value determined by the reasonable application of a reasonable valuation method. The determination of whether a valuation method is reasonable, or whether an application of a valuation method is reasonable, is made based on the facts and circumstances as of the valuation date.

Factors to be considered under a reasonable valuation method include, as applicable, the value of tangible and intangible assets of the corporation, the present value of future cash-flows of the corporation, the market value of stock or equity interests in similar corporations and other entities engaged in trades or businesses substantially similar to those engaged in by the corporation whose stock is to be valued, the value of which can be readily determined through objective means (such as through trading prices on an established securities market or an amount paid in an arm’s length private transaction), and other relevant factors such as control premiums or discounts for lack of marketability and whether the valuation method is used for other purposes that have a material economic effect on the service recipient, its stockholders or its creditors. The use of a valuation method is not reasonable if such valuation method does not take into consideration in applying its methodology, all available information material to the value of the corporation. Similarly, the use of a value previously calculated under a valuation method is not reasonable as of a later date if such calculation fails to reflect information available after the date of the calculation that may materially affect the value of the corporation (for example, the resolution of material litigation or the issuance of a patent) or the value was calculated with respect to a date that is more than 12 months earlier than the date for which the valuation is being used. The corporation's consistent use of a valuation method to determine the value of its stock or assets for other purposes, including for purposes unrelated to compensation of service providers, is also a factor supporting the reasonableness of such valuation method.

A corporation's consistent use of the Independent Appraisal method or the Internal Valuation Report method of valuation (discussed above in this memorandum) is presumed (subject to rebuttal) to result in a reasonable valuation.

The consistent use of a valuation method means the consistent use of the method for all equity-based compensation arrangements, including with respect to stock rights, for purposes of determining the exercise price, and with respect to stock appreciation rights not paid in stock, for purposes of determining the payment at the date of exercise, and for stock appreciation rights or stock options paid in stock subject to a put or call right providing for the potential repurchase by the service recipient, or other obligation of the service recipient or other person to purchase such stock, for purposes of determining the payment at the date of the purchase of such stock. Notwithstanding the foregoing, the corporation may change the method prospectively for purposes of new grants of equity-based compensation, including stock rights. In addition, where after the date of grant, but before the date of exercise, of the stock right, the corporation's stock to which the stock right relates becomes readily tradable on an established securities market, the corporation must use for valuation purposes the last sale price of the stock before or the first sale price of the stock after the date of grant, the closing price on the trading date before or the trading day of the grant, or any other reasonable basis using actual transactions in the stock as reported by the market and consistently applied.

Restricted Stock

In many cases, granting stock subject to buy-back restrictions is preferable to granting options. In the early stages of a company, when its stock may have little or no value, the company might grant a block of shares directly to each employee, while at the same time requiring each employee to sign a buy-back agreement that gives the corporation the right to buy the shares back for a nominal amount in the event the employee leaves the company within a certain time period. These restrictions might lapse ratably over time. For example, the buy-back agreement might provide that the company has the right to buy back 100% of the employee's shares if he or she leaves within the first year of employment; the right to buy back 80% of the employee's shares if he or she leaves during the second year of employment; and so on. After the fifth year, the corporation would no longer have any buy-back rights. Restrictions might lapse monthly, quarterly or yearly and usually end after two to four years.

Using this arrangement, the corporation gives the employees an actual ownership stake. They have current voting rights and the rights to any dividends declared. They participate in shareholders' meetings and feel more like actual co-owners than do option holders who are granted only options, are not invited to shareholders' meetings and do not have any voting rights.

The tax aspects of this arrangement can be harsh to the employee, however, if he or she does not make an "83(b) election." The 83(b) election allows the employee to avoid the possibility of substantial income in the future upon the lapse of the restrictions contained in the buy-back agreement. Please see "The 83(b) Election and Your Start-Up's Compensation Program" on this website for more information on restricted stock and the 83(b) election.

If the value of the stock is low at the time of grant of restricted stock, the employee will have little or no income at that time; and if he or she properly and timely files an 83(b) election, future income at the time the restrictions lapse will be avoided. In this connection a valuation along the lines of 409A (discussed above) is advisable prior to the date of grant. Another substantial benefit of the restricted stock arrangement over options is that for capital gains purposes, the employee’s holding period with respect to the stock begins immediately at the time of grant, and for long-term capital gains will be a one-year holding period. Compare this to the holding period requirements with respect to ISO's for capital gains treatment discussed above.

Some Alternatives to Stock Options

There are also alternatives for equity-based compensation of employees. One alternative is to grant stock appreciation rights ("SAR's"). SAR's are simply contractual rights to receive, either in cash or stock, the appreciation in the value of stock over a period of time. The granting of SAR's, obviously, would require some type of current valuation of the company's shares, like ISO's. SAR's are subject to the provisions of Code Section 409A, discussed above.

Another alternative is phantom stock, which is similar to an SAR. The employer simply credits the employee with hypothetical shares of stock. Any dividends would be credited to the employee's account (not actually paid). At a specified payout date, the employee would receive the value of his account, in cash or shares, or just the increase in value of his account from the date of creation. If the company does not anticipate ever going public, this may be an attractive alternative.

These two alternatives simplify things for the employer in many ways. First, the company will not have any additional shareholders to vote or who need to receive notices of meetings and the like. Second, the tax aspects may be simpler – generally, the employee will have taxable income when he receives the payment (whether in stock or shares) (subject to differing treatment if there are restrictions on transfer which will lapse), and the employer has a deduction at the same time. Also, if the employer is concerned about having cash available to make the payments, it can state from the outset that the choice to pay in shares or cash is at the company's sole discretion.

A third alternative type of employee bonus plan is one that is based on EBITDA, cash flow, or some other revenue-based criterion. The company could set up a contract that states that if its profits reach level X in any given fiscal year, then the company will distribute amount Y in cash to its employees, based on a formula which would take into account years worked, pay level, etc. Employees might like this plan even more than options. Options are sometimes confusing to employees, and often they don't see how they're ever going to cash out.

Stock options and their alternatives can provide valuable incentives for employees. Understanding the different choices and their effects will help you decide what is right for you.

© 1997-2015 Julia K. O'Neill

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