Statutory and Non-Statutory
There are two types of stock options, statutory stock options and non-statutory stock options. Statutory stock options are options that are granted under either an employee stock purchase plan or an incentive stock option plan. Non-statutory stock options are options that are otherwise granted.
Taxation of Statutory Stock Options
Generally, an employee is not taxed upon receipt or exercise of a statutory stock option, but upon sale of the stock. Stock sales are taxed either as short-term or long-term capital gains based on the holding period. Holding period of longer than one year will qualify the gain as long term- which is usually preferential.
Taxation of Non-Statutory Stock Options
When a non-statutory stock option is taxed depends on whether its fair market value“ can be readily determined.” If an employee receives a non-statutory stock option that has a readily determinable value at the time of grant, it is treated like other property received as compensation and taxed as ordinary income.
Readily Determinable Value
- The value of an option can be readily determined, if it is actively traded on an established market.
- The value of an option that is not actively traded on an established market can be readily determined, only if:
(i) the employee can transfer the option;
(ii) the employee can exercise the option immediately in full;
(iii) the option or the property subject to the option is not subject to any condition or restriction (other than a condition to secure payment of the purchase price) that has a significant effect on the FMV of the option;
(iv) the value of the option privilege can be readily determined.
If the option’s value is not readily determinable at the time of grant (even if it is determined later), the employee is not taxed until she exercises or transfers the option.
When an employee exercises a non-statutory stock option that did not have a readily determinable value at the time of grant, the restricted property rules apply.
Restricted Property Rules
Under the restricted property rules, property is taxed when it becomes “substantially vested.”
Property is “substantially vested” when:
(i) it is transferable; OR
(ii) it is not subject to a substantial risk of forfeiture.
Property is “transferable” if it can be sold, assigned, or pledged to any person (other than the grantor) and if the person who receives the interest in the property is not required to give up the property, or its value should the substantial risk of forfeiture occur.
Substantial Risk of Forfeiture
Generally, a “substantial risk of forfeiture” exists only if rights in property transferred are conditioned, directly or indirectly, either on the future performance (or refraining from performance) of substantial services by any person or on the occurrence of a condition related to a purpose of the transfer.
An election under section 83(b) of the Internal Revenue Code may provide a preferential tax outcome but MUST be timely filed.
Hold onto stock for longer than one year so that stock will be subject to long-term capital gain treatment at sale rather than short-term.