Stock Option Path to Riches - Part 1

This column, in slightly different format, originally appeared in The San Francisco Examiner Newspaper, January 17, 1999

Copyright 1999 Robert L. Sommers, all rights reserved.

[First to a two-part series]

A Stock Option Path to Riches

This is a story about Joe Cobal who decided to work for a Silicon Valley start-up ("Start-Up) at 70% of his previous earnings. But he also received the prized perk: For each year (12-month period) he worked, Joe would receive an option to purchase 50,000 shares of Start-Up, at one penny ($.01) per share. Each option would expire 10 years later. The company's current stock value was ten cents ($.10) a share, but was not publicly traded. The options had no other restrictions.


Joe worked for three years and received his stock options on December 31st each year. On January 2, 1997, Public, a publicly traded company bought Start-Up, paying $20.00 a share. Answer the following questions:

If Joe exercises his options prudently, upon his sale of Start-Up stock Joe will receive: (a) $50,000; (b) $150,000; (c) $3,000,000? The price Joe will pay to exercise his options is: (a) $5,000; (b) $15,000; or (c) $1,500? If you chose (c) for both answers, you understand why, particularly in Silicon Valley, stock options are the '90s equivalent of the California gold rush.


Stock Options in General

A stock option is, basically, the right to buy a fixed number of shares of stock for a set purchase price (the "strike" price) during a specific period, i.e., Joe's right to buy 50,000 shares of Start-up common stock at $.01 a share until December 31, 2005.


Employment-Related Stock Options

In recent years, stock options have been successful as an inducement by a company to employees and independent contractors. Because options have value, receipt of an option in an employment context raises income tax issues. Stock options are divided into "statutory" stock options which meet the Internal Revenue Code provisions 421 through 424 and all others ("nonstatutory").


Nonstatutory Stock Options

An employee receiving a nonstatutory stock option may be taxed, in most cases, at any of the following times: (1) when the option is received; (2) when he exercises the option; or (3) when restrictions (if any) on disposition of the stock (acquired by the option) lapse.

Employees or independent contractors receiving nonstatutory stock options are taxed upon receipt, if the option has a readily ascertainable fair market value (FMV). This rule usually applies to publicly traded stock. In almost all other situations, however, the employee is taxed when the option is exercised. In either case, the income is the FMV of the stock minus the strike price. In contrast, employees who receive a statutory stock option are not taxed until they sell the stock.

Most companies require that employees work for a requisite period or meet certain performance goals before they are eligible for stock options. Once those requirements are satisfied, the options become "vested," regardless of whether or not he chooses to exercise any options.

For instance, if Start-Up's stock had a readily ascertainable FMV of $.10 per share, Joe would have received $4,500 in compensation since he became vested upon his receipt of the options ($5,000 FMV for Start-Up's stock, less the strike price of $500 = $4,500). Start-Up takes a $4,500 deduction for "compensation" paid to Joe when he receives the income.


IRC Sec. 83(b) Election

Under IRC Sec. 83(b), Joe may elect immediate taxation on the option, rather than wait until any restrictions placed on the option have lapsed. A Sec. 83(b) election ensures that any future stock appreciation is not taxed as compensation, and the holding period commences for calculating long-term capital gains.


Tax Planning Opportunities

Once Joe became vested, he should consider immediately exercising the option to acquire the actual stock, since any appreciation will qualify for long-term capital gains treatment, up to a maximum federal tax of 20%, provided he holds the stock at least 12 months.

If, however, Joe exercised his options, then immediately sold the stock, he'd be subject to ordinary income treatment and could be taxed as high as 39.6% federal.

The Lesson: Ascertain whether your stock option plan is nonstatutory (read your stock-option plan); if it is, consider exercising the option the when you must take the gain as income. This decision depends on the cost of exercising the option and whether or not you anticipate selling your stock once you qualify for long-term capital gains.

[Next column: Statutory stock options]




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