How to offer your staff stock options

Stock options are a great way to provide incentives to any and all of your employees.Ownership in a company can motivate employees to work harder and feel like they are part of the company in a unique way.Appreciation in stock price means more economic benefit to the employee if the company succeeds.Options can be granted to all employees, a class of employees or to only key executives.They can be a powerful portion of an employees' compensation package especially when seeking to hire or retain key management personnel.

Tax law distinguishes two types of stock options and provides differing treatment for each.Incentive Stock options, or ISOs receive preferential tax treatment.Non Qualified Stock Options or NQSOs do not receive any preferential tax treatment like ISOs.ISOs are subject to certain non-discrimination rules under tax law and often benefit a wide classification of employees.NQSOs have no such restrictions and can be provided to key employees or even single employee.

A stock option is simply an option granted to buy a share of stock at a price typically below the current market price for that stock.Under tax law options are taxable compensation to the employee.The rules under the Internal Revenue Code for determining the taxability of the option and the disposition of the underlying stock are complex and assistance of a tax advisor is recommended.It should be noted here that the taxable portion of any taxable event related to options is always based on the difference between the exercise price and fair market value at the time of a taxable event.

As mentioned above, ISOs receive preferential tax treatment.If an employee exercises the options and holds the stock for one year they have no taxable compensation at the time of the exercise and the stock is taxed under the lower capital gains rate when sold.If they do not hold the stock one year the sale is taxed as ordinary income at the employee's regular tax rate. Another ugly twist is even if the employee holds the stock one year the exercise generates income for purposes of computing Alternative Minimum Tax (AMT) and often this will cause the taxpayer to be subject to that tax.However, if AMT it triggered an AMT credit would be available to offset regular tax in future years when the stock is actually sold.

For NQSOs the employee will be subject to tax at their ordinary income tax rate at the time of exercise.Taxable income is equal to the difference between the exercise price and the fair market value of the stock at that time unless the stock is subject to forfeiture in the future. In that case that taxable event occurs when the forfeiture lapses.Then, taxable income is computed based on the market value when the forfeiture lapses. To complicate this further, if there is a forfeiture provision the employee can elect at the time of exercise to include the taxable portion currently.An employee may wish to do this if they think the future fair market value will be higher then it is at the time of exercise. Various types of forfeiture provisions cans be used to plan for the timing of taxability.Most typical is some sort of vesting schedule.

One difficulty arises when using options in a closely held business where there is not a readily ascertainable market value.Since the compensatory portion of the option is based on fair market value how is this determined for a closely held business when there is no market for the stock?The best method is to obtain a valuation of the company by a CPA or other certified valuation analyst. However this adds to the cost of the stock option plan.Other rule of thumb methods may be used but IRS prefers a full valuation.