Dear Clients and Friends:

More and more employers are granting stock options to employees as part of their compensation packages. From a tax standpoint, there are two kinds of options -- statutory and nonstatutory. 'Incentive Stock Options,' or ISOs, as they are commonly known, are statutory options, because they are specifically provided for in the Internal Revenue Code and are subject to numerous qualification requirements. Options that don't meet these requirements are nonstatutory options, also known as nonqualified options. Both kinds of options have tax advantages, but there are quite a few differences between them. Here is some basic information on the taxation of compensatory stock options that may help you better understand how best to benefit from them.

Option grant: If you have incentive stock options (ISOs), you are not taxed on option grant. If you have nonstatutory options, you are taxed on option grant only if the options have a 'readily ascertainable' fair market value at grant, which is seldom the case. IRS rules say that options don't have a readily ascertainable value at grant unless they are actively traded or are immediately transferable, fully exercisable, and the options and the option stock are unrestricted. In addition, the value of the 'option privilege' must be readily ascertainable. In the unlikely event that a nonstatutory option is taxable at grant, you have compensation income at that point.

Option exercise: No regular income tax is owed on the exercise of an ISO. Tax isn't owed until the stock is sold. However, the bargain element at exercise, which is the difference between the value of the option stock at exercise and the (lower) price you pay for it is considered to be income when figuring your alternative minimum tax (AMT). Even if you're usually not subject to the AMT, exercising ISOs may push you into its range. (If you are subject to the AMT in the year you exercise ISOs, you may be entitled to a tax credit against your regular income tax in some later year when you are not subject to AMT.)

When you exercise a nonqualified option that wasn't taxed at grant, you are subject to tax at ordinary income rates at exercise on the difference between the value of the option stock at that time and the price you paid for it (plus any price you may have paid for the option, although generally that will be zero). This is compensation income that is subject to payroll taxes and income tax withholding. Taxes may be withheld from your salary or other compensation income, or you may have to sell some of the stock to cover the withholding or make some other arrangement with your employer. However if the option stock is nontransferable or subject to a substantial risk of forfeiture, you aren't charged with compensation income until those restrictions no longer exist. In that case, you can choose to pay tax on exercise so that all gain from that point on would be capital gain.

Sale of option stock: When you sell stock acquired through the exercise of an incentive stock option (ISO stock), you generally are taxed at favorable long-term capital gain rates on the difference between the price you paid for the stock and the amount you realize on its sale. However, if you sell the stock within two years of the option grant or within one year of the option exercise, you are hit with compensation income to the extent of your bargain element at exercise. The balance of your gain is capital gain, which will be taxed at favorable rates if you've held the stock for more than one year on the sale date.

When you sell stock acquired by exercise of a nonqualified option, you have capital gain if you were subject to tax either at option grant or exercise, or when restrictions on your option stock lapsed. Otherwise, you have compensation income at the time of the sale.

As you can see, the tax rules for compensatory stock options are quite complex. Please call (315) 363-3338for an appointment if you have additional questions about your options or if you would like to do some tax planning in relation to them.

Very truly yours,

G. William Hatfield
Certified Public Accountant
Certified Financial Planner