In today's tight labor market, obtaining and retaining employees are of critical importance. One common approach that often achieves both of these goals is the use of stock options. Stock options are a particularly strong incentive because they give employers the ability to compensate employees without depleting valuable cash resources and provide employees the opportunity to share in gains usually reserved for stockholders. Of course, stock options are valuable only if the stock of the employer appreciates in value.

Employee stock options give employees the right to purchase stock at a given price, within a given time frame. Generally, the option price, the price at which the employee purchases the stock, is the fair market value at the date the option is granted. The time frame is often five to ten years. Typically there is a vesting period, during which the option may not be exercised. After the vesting period, the employee may exercise the option by purchasing the stock from the employer at the specified price. The timing and manner of exercise require careful planning.

For federal income tax purposes, there are two types of options: Qualified "Incentive Stock Options" (ISOs) which are typically granted only to executives and key employees and Non-Qualified Stock Options (NQSOs) which are granted to all employees. Often executive and other key employees receive both ISOs and NQSOs.

The employee does not generally realize any taxable income upon either receipt or vesting of either type of option. When the option is exercised however, the difference between ISOs and NQSOs is dramatic.

Non Qualified Stock Options
When an NQSO is exercised, the excess of the fair market value of the underlying stock on the exercise date over the exercise price is treated as compensation. This means the employee pays tax at regular rates on the appreciation of the stock at the time of exercise. This compensation element, which is included in the employee's form W-2 for the year, is immediately subject to withholding of federal, state and local taxes including social security and medicare taxes. The employer obtains a tax deduction for the compensation element.

The employee's tax basis in the stock acquired is equal to the exercise price paid plus the amount included in income. The employees holding period for the stock begins on the exercise date. Thus, if the employee sells the shares more than one year after the exercise date, any appreciation occurring after the exercise date will be taxed as a long-term capital gain at a maximum rate of 20%.

An employee considering exercising NQSOs must determine how to generate the funds needed to cover the exercise price and the withholding of payroll taxes. This may be accomplished by use of personal funds or through borrowing. Use of a margin loan results in investment interest expense. Often the dividends from the stock cover part, or all, of the interest on the loan. The interest on the loan is deductible to the extent of the employee's investment income. Many employers offer "cashless exercises" in which the options are exercised and a portion of the stock is sold in order to cover the exercise price and payroll taxes. The balance of the stock is then delivered to the employee.

In some cases an employer may allow the employee to surrender shares of stock the employee currently owns in order to cover the exercise price. This is advantageous because the tax law allows individuals to exchange stock for stock in the same company tax-free.

Often, the exercise of stock options pushes the employee's compensation to higher than normal levels. Due to the progressive nature of federal income tax rates, employees may benefit by spreading out the exercise of stock options over a period of two or more years. By spreading out the income, it is less likely that the employee will be pushed into a higher tax bracket.

Spreading out the exercises may also work against the employee two different ways. First, additional ordinary income may result if the price of the stock increases between the exercise dates. Because the appreciation is taxed at ordinary rates, the employee may want to exercise as soon as possible to begin the holding period for long term capital gain treatment. Second, if the stock value declines, failure to exercise options and sell the stock would result in the employee suffering an economic loss.

Qualified Incentive Stock Options
Exercise of an ISO has a completely different treatment. Generally, there is no compensation element with an ISO and hence no income tax on the date of exercise. Further, since there is not any compensation element, there is no payroll tax withholding, and no need to immediately sell stock to cover taxes. If the employee holds the stock for more than one year after exercise and more than two years from the date the option was granted, the entire amount of the appreciation is taxed as long term capital gain. If the ISO stock is sold within two years from the grant date or one year from the exercise date, the sale is treated as compensation and the excess of the fair market value of the stock over the exercise price is taxed as ordinary income.

Although the exercise of ISOs is not subject to regular tax there is an adjustment, equal to the implied "compensation element", for purposes of calculating the alternative minimum tax (AMT). The AMT is a separate tax calculation, in which certain "preferences" and "adjustments" are added to or subtracted from regular taxable income in order to compute alternative minimum taxable income. A separate minimum tax rate is imposed upon alternative minimum taxable income and the result is then compared to the taxpayer's regular tax. The excess is the AMT for the year and is added to the regular tax liability.

Any AMT paid may be recovered in future years through the minimum tax credit (MTC). The MTC represents the portion of the AMT paid relating to timing differences, such as the ISO adjustment. If the taxpayer's regular tax liability in a future year exceeds his/her minimum tax liability for that year, the credit will reduce the regular tax down to the minimum tax liability. If the MTC is not completely absorbed in any one year, it is carried forward indefinitely to subsequent years. At the time the shares are sold there is a negative adjustment for AMT purposes. This results in lower minimum tax in the year of sale, and generally results in use of the MTC in the year of sale.

In order to minimize the AMT (or accelerate use of a MTC) certain planning techniques may be employed. The most common technique is to exercise only so many ISOs as are needed to increase the minimum tax to equal the regular tax. This is possible because the minimum tax is generally lower than regular tax absent any adjustments. Another approach involves selling enough ISO shares previously acquired in the same year as an ISO exercise. This allows the adjustments to offset each other, eliminating the AMT. A third approach involves exercising NQSOs and ISOs in the same tax year. The compensation element of the NQSOs increases the regular tax, which reduces the effect of the AMT adjustment from the ISOs.

As you can see the use of employee stock options offers both opportunities and pitfalls with far-reaching economic and tax consequences. Careful planning is necessary to insure that an employee will obtain the most favorable results.