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Employee Stock Option: Tax Treatment and Advantages

by: sahil | last updated: March 29, 2010
Category: Personal Finance | Tags: employee stock options, stocks, employee benefits, call option, employee plans, workers benefits, employment plans

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Employee Stock Option: Tax Treatment and Advantages

Employee Stock Option is a call option available to an employee which is a stock option issued as a type of non-cash compensation. A call option is nothing but the option open for a person to buy shares of stocks at a specified time in the future. The benefit for the company that provides such an option is that if the performance of the company rises; so does its stock and the employee receives direct financial benefit by helping in achieving a higher amount of productivity.

This simply means that the employee stock option provides workers with an incentive to work in ways that will improve the company’s stock price. Employee stock options are typically accessible to management as a component of their executive compensation package. They could also be accessible to non-executive level employees, particularly by businesses that are not yet gainful, as they might have hardly any other means of compensation.

On the other hand, employee-type stock options can be given to non-employees: promoters, lawyers, consultants, and suppliers for services provided. Employee stock options can be comparable to warrants, which are call options given by a company with regard to its own stock. There are many differences between an employee stock option and standard exchange traded options. These include changes in the exercise price, quantity, vesting, duration, the non-transferable factor, and taxation issues.

According to US generally accepted accounting principles in effect before June 2005, stock options granted to employees did not require to be acknowledged as an expense on the income statement when granted, even though the cost was revealed in the notes to the financial statements. This permits a potentially hefty form of employee compensation to not show up as expenditure in the existing year, and consequently, presently exaggerate revenue. Numerous experts emphasize that over-reporting of income by techniques such as this by American corporations was one causative factor in the Stock Market recession of 2002.

Employee stock options must be expensed under US GAAP in the United States. Every company must start expensing stock options no later than the first reporting period of a fiscal year starting after June 15, 2005. As the majority companies have fiscal years that are calendars, for nearly all companies this means starting with the first quarter of 2006. Consequently, companies that have not willingly started expensing options will only see an income statement outcome in fiscal year 2006.

There are numerous types of stock options offered to people in the United States and differ in their tax treatment. These are Incentive stock options, Put options, and Non-qualified stock options. The tax treatment of these depends on whether a taxable event has occurred when the option was granted to the employee.

In the United States, according to the IRS (Internal Revenue Service), no taxable event occurs when the option is granted. However, the employee may or may not be taxed on the exercise of such option. For instance, Non-qualified stock options are taxed upon exercise; however Incentive stock options (ISO) are not, presuming that the worker complies with certain supplementary tax code requirements.