CRS Report Examining Tax Treatment of Employee Stock Options

[1] The practice of granting a company's employees options to purchase the company's stock has become widespread among American businesses. Employee stock options have been praised as innovative compensation plans that help align the interests of the employees with those of the shareholders. They have also been condemned as schemes to enrich insiders and avoid company taxes.

[2] The tax code recognizes two general types of employee options, "qualified" and nonqualified.

[3] Qualified (or "statutory") options include "incentive stock options," which are limited to $100,000 a year for any one employee, and "employee stock purchase plans," which are limited to $25,000 a year for any employee. Employee stock purchase plans must be offered to all full-time employees with at least 2 years of service; incentive stock options may be confined to officers and highly paid employees. Qualified options are not taxed to the employee when granted or exercised (under the regular tax); tax is imposed only when the stock is sold. If the stock is held I year from purchase and 2 years from the granting of the option, the gain is taxed as long-term capital gain. The employer is not allowed a deduction for these options. However, if the stock is not held the required time, the employee is taxed at ordinary income tax rates and the employer is allowed a deduction. The value of incentive stock options is included in minimum taxable income in the year of exercise. They are not currently subject to employment (FICA and FUTA) taxes.

[4] Nonqualified options may be granted in unlimited amounts; these are the options making the news as creating large fortunes for officers and employees. They are taxed when exercised and all restrictions on selling the stock have expired, on the difference between the price paid for the stock and its market value at exercise. The company is allowed a deduction for the same amount in the year the employee includes it in income. They are subject to employment taxes also.

[5] The principal tax issue affecting qualified stock options is the application of employment taxes to them. IRS has proposed taxing them as wage income in the year of exercise, reversing a long-standing position. Many business groups have disagreed with this position, and legislation is pending in the 107th Congress that would reverse it (a provision in the House-passed H. R. 3762 and S. 1383).

[6] Although taxes are postponed on nonqualified options until they are exercised, the deduction allowed the company is also postponed, so there is generally little if any tax advantage to these options. However, imposing a tax penalty on nonqualified stock options has been proposed as a means of forcing publicly held companies to deduct their value on their financial reports to stockholders. Bills in the 107th Congress (S. 1940 and H. R. 4075) would restrict the tax deduction for nonqualified stock options to the amount deducted on the companies' financial statements.

This report is for background purposes and will not be updated.

 Contents

[8] Employee stock options have been extolled as innovative compensation plans benefitting companies, stockholders, and employees.² They have been condemned as schemes to enrich insiders at the expense of ordinary stockholders and as tax avoidance devices.³

[9] This report examines the tax treatment of various types of employee stock options recognized by the Internal Revenue Code and discusses some of the issues that have arisen because of the real and perceived tax benefits accorded them.

Definition

[10] Employee stock options are contracts giving employees (including officers), and sometimes directors and other service providers, the right to buy the company's common stock at a specified exercise price after a specified vesting period. The exercise price is typically the market price of the stock when the option is granted (although it can be more or less, as discussed later under "Types of employee stock options"), the vesting period is usually two to four years, and the option is usually exercisable for a certain period, often five or 10 years. The value of the option when granted lies in the prospect that the market price of the company's stock will increase by the time the option is exercised. (If the price falls, the option will simply not be exercised; the contract does not obligate the employee to buy the stock.) Employee stock options typically cannot be transferred and so have no market value.

[11] To illustrate, suppose that Ceecorp, Inc., is a publicly held corporation whose stock is selling for $10 a share on January 1, 1998. As a part of her compensation plan, Ceecorp's chief financial officer was granted options on that date to buy 1,000 shares of stock for $10 a share any time over the next 10 years, subject to certain conditions. One condition was that she had to work for the company until she exercised her options. Another was that her right to the options vested over a period of four years, one-quarter each year. This meant that on January 1, 1999, she received an unrestricted right to buy 250 shares of stock for $10 a share, and so on each year until, on January 1, 2002, all of the options were fully vested and she could buy 1,000 shares if she chose.

[12] Suppose that Ceecorp's stock had risen to $30 a share on January 1, 1999, when the CFO became vested with the right to buy 250 shares, with no further restrictions on her ownership of the stock. She could pay the company $2,500 for the 250 shares, which were at that point worth $7,500, with an immediate gain of $5,000 (ignoring taxes for the moment) in either cash if she sold the stock or property if she held on to it. She could similarly exercise the other options as they became vested or wait for later stock price changes. The options would continue to be worth extra compensation for her as long as Ceecorp's stock was selling for more than $10 a share.

[13] When she exercised her options, the company had to be prepared to sell her the stock at the below-market exercise price. So on January 1, 1999, if she chose to buy 250 shares of Ceecorp stock, the company had to either buy 250 shares of its own stock for $7,500 or issue 250 shares of new or treasury stock that it could have sold for $7,500. When it sold these shares to the CFO for $2,500, the economic reality was the same as if it had paid her $5,000 in cash: she received additional compensation of $5,000 and Ceecorp was out $5,000 that it would have still had if she had not exercised her options.

Advantages and Disadvantages of Stock Options

[14] Paying for the services of employees or directors by the use of stock options has several advantages for the companies. Start-up companies often use the method because it does not involve the immediate cash outlays that paying salaries involves; in effect, a stock option is a promise of a future payment, contingent on increases in the value of the company's stock. It also makes the employees' pay dependent on the performance of the company's stock, giving them extra incentive to try to improve the company's (or at least the stock's) performance. Ownership of company stock is thought by many to assure that the company's employees, officers, and directors share the interests of the company's stockholders. Because current accounting rules do not require stock options to be deducted from income in the companies' financial statements, net profits reported to shareholders are larger than they would be if the same amounts were paid in cash.

[15] Critics of the stock option trend, however, argue that the practice gives officers and directors a strong incentive to inflate stock prices and that there is no real evidence that it does improve performance. (Many of the leading users of stock options were among the companies suffering substantial recent stock losses.) It is also pointed out that the accounting rules that make stock options attractive also serve to hide their cost from other shareholders, whose own shares will be less valuable if there is large dilution of equity through the use of stock options.

[16] Receiving pay in the form of stock options can be advantageous to employees as well. Stock options can be worth far more than companies could afford to pay in direct compensation, particularly successful start-up companies. Some types of stock options receive favorable income tax treatment. Receiving pay in the form of stock options serves as a form of forced savings, since the money cannot be spent until the restrictions expire.

[17] Of course, it is a risky form of pay, since the company's stock may go down instead of up. Some employees may not want to make the outlay required to buy the stock, especially if the stock is subject to restrictions and cannot be sold immediately. And some simply may not want to invest their pay in their employer's stock.

Types of Employee Stock Options

[18] There are a number of variations on the general idea of an employee stock option. Some variations are due to the tax rules that govern them, and some are because of the intended use of the options by the companies granting them. This report focuses on the tax treatment of the options and the issues arising from the tax treatment; but one of the issues is whether the tax code has kept up with the proliferation of ways options can be designed.

[19] The Internal Revenue (IR) Code recognizes two fundamental types of options. One is called "statutory" or "qualified" options because they are accorded favorable tax treatment if they meet the Code's strict qualifications (IR Code Section 421-424). Generally, the value of these options is not taxed to the employee nor deducted by the employer. The second is "nonqualifted" options, which have no special tax criteria to meet, but are taxed to the employee as wage income when their value can be unambiguously established (which IRS says is when they are no longer at risk of forfeiture and can be freely transferred). They are deductible by the employer when the employee includes them in income (IR Code Section 83).

[20] Some options have special features designed to do more than just compensate employees. Some, such as the employee stock purchase plans discussed below, are granted at less than the market price of the stock, to make it easier for recipients (particularly lower level employees) to buy stock. Nonqualified options are often used to reward management, and some are only exercisable if certain goals are met. "Premium" options are granted at a price higher than the current price of the stock; "performance-vested" options are not exercisable until a specific stock price is reached. "Indexed" options are repriced based on broad stock indices, to differentiate between the company's performance and the market's performance. There are other variations.⁴

[21] Options are not the only way to use a company's stock to compensate employees. Direct grants of stock are always possible, and can be hedged with restrictions similar to those governing the exercise of options. "Stock appreciation rights" and "phantom stock" plans pay employees the cash equivalent of the increases in the company's stock without their actually owning any.⁵

[22] These various plans have different tax consequences for companies and employees.

Incentive Stock Options

[24] Incentive stock options (IR Code Section 422) must be granted in accordance with a written plan approved by the shareholders. The plan must designate the number of shares to be subject to the options and specify the classes of employees eligible to participate in the plan. The option price must be no less than the market value of the stock at the time of the grant, and it must require exercise within 10 years from the time it was granted. The market value of the stock for any incentive stock options exercisable in any year is limited to $100,000 for any individual. This is the limit on the amount that receives favorable tax treatment, not on the amount that may be granted; options for stock exceeding $100,000 in market value are treated as nonqualifying options. There are additional restrictions for options granted to persons owning more than 10% of the outstanding stock.

Employee Stock Purchase Plans

[25] An employee stock purchase plan (IR Code Section 423) must also be a written plan approved by the shareholders, but this type of plan must generally cover all full-time employees with at least two years of service (or all except highly compensated employees). It must exclude any employee who owns (or would own after exercising the options) 5% or more of the company's stock. The option price must be at least 85% of the fair market value of the stock either when the option is granted or when it is exercised, whichever is less. The options must be exercised within a limited time (no more than five years). The plan must not allow any employee to accrue rights to purchase more than $25,000 in stock in any year.

Current Tax Treatment

[26] Both types of qualified stock options receive some tax benefit under current law. The employee recognizes no income (for regular tax purposes) when the options are granted or when they are exercised. Taxes (under the regular tax) are not imposed until the stock purchased by the employee is sold. If the stock is sold after it has been held for at least two years from the date the option was granted and one year from the date it was exercised, the difference between the market price of the stock when the option was exercised and the price for which it was sold is taxed at long-term capital gains rates. If the option price was less than 100% of the fair market value of the stock when it was granted, the difference between the exercise price and the market price (the discount) is taxed as ordinary income (when the stock is sold).

[27] Companies generally receive no deduction for qualified stock options, so the tax advantage accrues to the employee, not the employer. Companies that would not be taxable anyway, such as start-up companies not yet profitable, would care little if at all about the tax deduction and would be expected to use this method of compensation. Many companies that are taxable grant qualified stock options, however, so these options must have some advantage that outweighs the tax cost. In some cases, the companies no doubt find that rewarding their employees with qualified stock options is worth the cost; in other cases, perhaps, the officers and employees who receive the options exercise special influence over the companies' compensation policies.

[28] If the stock is not held for the required two years from the granting of the option and one year from its exercise, special rules apply. The employee is taxed at ordinary income tax rates instead of capital gains rates on the difference between the price paid for the stock and its market value either when the option was exercised or when the stock was sold, whichever is less. The company is then allowed a deduction just as if the employee's taxable gain were ordinary compensation paid in the year the year the stock is sold.

[29] The favorable tax treatment of qualified stock options for employees is limited by the alternative minimum tax. For alternative minimum tax purposes, the difference between the exercise price and the stock's market value is considered a tax preference item in the year the option is exercised. Persons who are under the alternative minimum tax for other reasons or who are thrown into it by the exercise of a large amount of options may thus be subject to tax on their incentive stock options in the year that they are exercised. The alternative minimum tax paid on stock options could be allowed as a credit against regular tax in future years.⁶

[30] To illustrate the tax treatment of incentive stock options, suppose that the Ceecorp's grants to the CFO described previously were under an incentive option plan approved by the shareholders. The CFO could postpone taxation of her $5,000 gain by holding the stock until at least January 1, 2000 (1 year after she bought it and 2 years after the options were granted). Assuming the stock was still worth $30 a share, she could realize her gain at that point and be taxed at the 20-percent capital gains rate instead of her regular tax rate.

[31] However, if she were subject to the alternative minimum tax (from having other tax preference items, for example), she would have been required to include the $5,000 in alternative minimum taxable income in 1999 and could have been taxed at 26 or 28% on it that year. Any alternative minimum tax she paid in 1999 could be carried over to future years and used as a credit against regular tax in any year in which she had a regular tax in excess of her tentative minimum tax. (The credit is not refundable, but it can be carried over indefinitely.)

Tax Favored Treatment

[32] Continuing the tax advantages that qualified stock options receive is not often raised as an issue in their tax treatment. It is often argued that giving favorable tax treatment to a limited amount of compensation in the form of options helps spread the use of options to rank-and-file workers. (Nonqualified options, which are not tax favored, are more likely to go to officers and highly paid employees.) Employee stock ownership plans are explicitly promoted as a means for workers to become owners of their companies. In addition, the cost to the government is at least partially offset by the lack of a tax deduction at the company level. There may be a corporate governance issue in why publicly held companies are willing to incur an unnecessary tax cost for the benefit of officers and employees. (The company could offer nonqualified stock options, which are deductible; in fact, many companies do offer both incentive and nonqualified options to the same employees.)

Payroll Taxes

[33] Qualified stock options have not been considered wages for Federal Insurance Contribution Act (FICA) and Federal Unemployment Tax Act (FUTA) purposes in the past. The Internal Revenue Service (IRS) issued a ruling in 1971 to this effect (Revenue Ruling 71-52). However, the Tax Court later ruled that they were wages for calculating the research tax credit,⁷ and IRS acquiesced in that decision in 1997. Since then, IRS has said that it would be required to impose employment taxes on the options also, and it has made several attempts to impose the taxes in specific cases.⁸

[34] In 2001, IRS announced a proposed regulation that would subject the value of qualified stock options (the difference between the exercise price and the market price) to FICA and FUTA taxes in the year the options are exercised. This new rule would be effective January 1, 2003, and until that time IRS would not attempt to collect any taxes on the options. No change in income tax treatment is proposed, and income tax withholding would not be required.⁹

[35] The proposed regulation has received a very negative reaction in the public comments that IRS requested. Companies have argued that the additional tax cost and the paperwork burden of a new accounting requirement will discourage the granting of options and make them less attractive to employees. The critics argued that Congress explicitly excluded the value of an exercised qualified stock option from income, and that something cannot be "wages" if it is not also "income." The IRS, however, contends that only those items specifically excluded from wages in the IR Code are to be excluded.¹⁰

[36] A provision in H.R. 3762, the Pension Protection Act of 2002, would nullify the proposed rule and make qualified stock options permanently exempt from payroll taxes. A similar provision is in S. 1383. (Both bills were introduced in the 107th Congress.)

Alternative Minimum Tax

[37] Imposing the alternative minimum tax on qualified stock options reduces their tax advantage; of persons paying the AMT, the tax treatment is similar to the regular tax treatment of nonqualified options. Although the minimum tax exemptions of $35,750 for single taxpayers and $49,000 for joint returns limit the minimum tax to relatively high-income taxpayers, it does impose some burden on the otherwise tax-favored option plans.

[38] The minimum tax can make the receipt of qualified stock options an extremely complex problem. It is imposed in the year the options are exercised (and the stock is transferred without restrictions) at the AMT rates of 26 or 28%, and the basis of the stock then becomes, for AMT purposes, the market price of the stock. When the stock is sold, it will have two bases, one for the AMT and one for the regular tax. Double taxation will not result, because an alternative minimum tax credit will be available (if the employee is not again subject to the minimum tax) or an adjustment of minimum taxable income will be made (if he owes minimum tax again that year). Since taxpayers often will not know if they are subject to the minimum tax until the tax year is over, tax planning can be very difficult.

[39] Taxpayers may feel that an even more annoying issue lies in the fact that the price of the stock may go down after the minimum tax is imposed, causing them to have paid tax on profits they never see. However, this either results in a minimum tax loss in the year the stock is sold, which will reduce any minimum tax otherwise owed in that or future years, or a credit against regular tax in some future year.

Nonqualified Stock Options

[40] Employee options that do not qualify for tax-favored treatment are by far the most important (at least by value). Because there are no statutory limits on the amount of these options that can be offered, these are the options used to compensate corporate officers and highly paid employees. Unlike qualified options, these options can be offered to anyone "providing services" to the company, not just employees. Therefore, they can also be given to those who serve on the company's board of directors (or even to independent contractors). When news reports and policy analysts mention options, without other qualifications, they normally mean nonqualified options.

Tax Treatment

[41] Nonqualified options fall under the general rules governing the transfer of property other than money in return for services (IR Code Section 83). Basically, the rule is that the recipient receives income equal to the fair market value of the property (less any amount paid for it) when he receives an unrestricted right to the property and its fair market value can be reasonably ascertained. Stock options without a "readily ascertainable market value" are specifically excepted by Section 83(e)(3). (Qualified stock options are also excluded.)

[42] In the case of nonqualified options, IRS has ruled that options that are not tradable (as is almost always true of these options) have no "readily ascertainable market value." Therefore, their fair market value cannot be established until they are exercised and any restrictions on the disposition of the stock have been lifted. At that time, the value of the options is equal to the difference between the exercise price and the stock's current market price.¹¹ (There is a provision in Section 83(b) allowing the recipient of the options to elect to include their value in income in the year they are exercised, valuing them as if the stock were not restricted. However, no future deduction is allowed if the stock is later forfeited.)

[43] Nonqualified stock options exercised by employees are subject to FICA and FUTA taxes and income tax withholding, just as cash wages are.

[44] The company granting the options is allowed to deduct from income the same value of the options that the recipient includes in income, in the same year it is taxable to the recipient (Section 83(h)).

[45] If the options granted by Ceecorp to its CFO in our previous example were nonqualified options, there would be three notable differences from the qualified options assumed before. One is that she would have been immediately taxable on the difference between what she paid for the stock and what it was worth in the year she acquired it, so she would have owed income and FICA taxes on $5,000 in 1999. The second was that Ceecorp could deduct the $5,000 as employee compensation on its own tax return (and would also owe FICA and FUTA taxes on it). And probably most important in the real world (although not in our example), there would have been no limit on the value of the options granted, so a highly compensated officer like a chief financial officer could receive potentially large amounts of additional compensation.

Are Nonqualified Options Tax-Favored?

[46] Nonqualified options are not taxed to the recipient when they are granted or when they become vested, so receiving compensation in this form postpones the payment of taxes from when they would have been due on an equivalent amount of cash wages. However, the reason for not taxing them is the uncertainty of their actual value; the tax rules follow the practical path of postponing tax until their value is realized, as is the case with capital gains. In addition, the company's deduction of the compensation is also postponed, being allowed only in the same year that the recipient reports the income realized. Since most of these options go to highly compensated individuals, whose marginal tax rates would often be higher than the company's, the government probably suffers little if any revenue loss. So it could be argued that the individuals' possible tax advantage is more than offset by the companies' tax disadvantage, and the government should be indifferent to the issue.

The Issue of Tax Versus Book Income

[47] The treatment of stock options under the generally accepted accounting rules that govern the way companies report to stockholders, creditors, and regulators is quite different from the tax accounting rules. Originally, the accounting rules were of very limited scope. Because employee options were normally priced equal to the market price of the company's stock when they were granted, they were said to have no value. The fact that they were intended to have value and therefore serve as compensation was not taken into account. As they became more popular, however, the accounting standards were modified to require some recognition of their effect on a company's income. The current rule (FAS 123) requires companies to estimate the value of the options when they are granted (using an option pricing model) and show that amount, called the "fair value," as a cost over the years until the options are vested. In their published financial statements, the companies can either treat the estimated value of the options as a cost in calculating net income, or they can use the traditional valuing of the options (i.e., zero) in calculating net income and show the effect of deducting the estimated value in a footnote. Almost all companies have chosen to use the footnote method.

[48] In the very simple example used so far, Ceecorp and its CFO, the traditional valuation of the options when granted would be: the stock is selling for $10 a share, the options allow the CFO to buy it at $10 a share, so the options' value is zero. Ceecorp, like almost all public corporations, would probably calculate its net profit on its financial statement using this valuation. Under FAS 123, however, it would also use an estimating model to determine a market value. The model would estimate the likelihood that the stock would go up in value over the life of the option and take other variables into account and establish what the option might be worth on the open market when granted (if it could be marketed). So, Ceecorp might estimate that the "fair value" of the options when granted was $16 each, for a total value of $16,000, and report in a footnote to its financial statement an additional compensation cost of $4,000 each year for the four years over which the options vested. It would not account for the actual cost of the options when exercised on its income statement.¹²

[49] Several bills have been introduced in Congress over the years to restrict the tax deduction for options because of the differences with the accounting treatment.¹³ The bills attempt to change the companies' accounting practices, to make the cost of stock options more apparent to stockholders and investors; but the device chosen is to restrict the tax deduction allowed to the amount "treated as an expense" on the companies' books of account. Without further changes in either the accounting rules or the tax law, however, this approach does not in fact conform the tax and book treatment. The book expense is based on the estimated value of the options when granted and is charged off over the vesting period of the options. The tax deduction, in contrast, is allowed only when the options are exercised, and would, under this approach, be limited to the smaller of the estimated or actual values. In addition, the amount deducted by the company would no longer necessarily equal the amount taxed to the individual.

Executive Compensation Limits

[50] The tax deduction for compensation paid to the chief executive officer and certain other highly paid officers of a publicly held corporation is limited under IR Code Section 162(m) to $1,000,000 annually, with a number of exceptions. The most important exception is incentive compensation; with shareholder approval, compensation rewarding officers for performance is not subject to a deduction limit. Since stock options have value only if the stock performs well, compensation in the form of stock options is not subject to the executive compensation limits if they are granted in accordance with a plan approved by the shareholders and meet the other requirements of Section 162(m).

² Ibid.

³ Warren Buffett, "Stock Options and Common Sense," The Washington Post, April 9, 2002, p. A 19; Martin A. Sullivan, "Stock Options Take $50 Billion Bite Out of Corporate Taxes," Tax Notes, March 18, 2002, p. 1396.

⁴Shane A. Johnson and Yisong S. Tian, "The Value and Incentive Effects of Nontraditional Executive Stock Option Plans," Journal of Financial Economics, vol. 57 (2000), pp. 3-34.

⁵See Joint Committee on Taxation, Present Law and Background Relating to Executive Compensation (JCX-29-02), April 17, 2002, p. 26.

⁶ For a description of the alternative minimum tax, see CRS Report RL30149, The Alternative Minimum Tax for Individuals, by Gregg A. Esenwein.

⁷Sun Microsystems, Inc., v. Commissioner, T. C. Memo. 1995-69.

⁸Sheryl Stratton, "Hearing on Stock Option Regs Should Be Livelier Than Most," Tax Notes, May 13, 2002, p. 968.

⁹Proposed Regulation REG-142686-01, Internal Revenue Bulletin 2001-49, p. 561.

¹⁰See Stratton, op. cit.

¹¹IR Reg. 1.83-7.

¹²It would account for the difference in its balance sheet. For a more complete discussion of the accounting issues, see Congressional Research Service, "Stock Options: Overview of Financial Accounting," by Bob Lyke. General Distribution Memorandum, May 6, 2002. 14 p.

¹³S. 1940 and H.R. 4075 in the 107th Congress, for example.