Business Vantage Point Blog

Stock options can be an important component of total rewards packages. For private companies, equity grants can be used to attract and retain qualified employees, consultants and directors by offering the potential for significant appreciation in the value of their awards and to align the interests of the company’s service providers with those of its shareholders and investors. Equity grants can also improve service provider productivity, resulting in increased company value, and preserve capital by paying less in cash compensation. Ensuring a stock option process is correct from the start is simpler — and cheaper — than fixing mistakes later.

Adopting any equity compensation plan, including a stock option plan, is subject to applicable state laws and a company’s foundational documents, e.g., the corporate charter and bylaws. Typically, a company’s board of directors is empowered to adopt a stock option plan, and a plan is deemed adopted when it is approved by the board of directors, unless the board’s approval is subject to the occurrence of a subsequent event. For more on delegating grantmaking authority under an equity compensation plan, see our previous blog post.

The Two Categories of Stock Options: ISOs and NQSOs

Stock options fall into two categories: incentive stock options (ISOs) and nonqualified stock options (NQSOs). ISOs provide employees with more favorable tax treatment than NQSOs. An individual who exercises an NQSO must pay ordinary income taxes on the excess of the fair market value of the underlying shares on exercise over the exercise price (the spread). However, ISOs are not subject to ordinary income taxes if the shares are held for both (1) one year from the date of exercise and (2) two years from the grant date. An employee incurs no income tax at the grant or upon the exercise of an ISO (although the spread is a tax adjustment item for purposes of calculating alternative minimum tax), and the profit (if any) made on the sale of the shares is taxed as a long-term capital gain.

As with ISOs, there is no tax at the grant of an NQSO. However, when an NQSO is exercised, ordinary income is recognized in an amount equal to the spread. When the shares are subsequently sold, there is a capital gain or loss on the difference between the sale price and the sum of the exercise price paid, plus the ordinary income recognized on exercise. Whether it is a long-term or short-term gain or loss depends on how long the shares are held.

What Conditions Must a Plan Meet for ISO Grants?

In order to be treated as an ISO under Section 422 of the Internal Revenue Code, and to therefore be subject to favorable tax treatment, the plan under which the ISO is granted must meet the following conditions. (Note: The terms of the ISO itself must also meet additional requirements.)

Conditions:

• The plan must designate the maximum aggregate number of shares that may be issued under the plan through ISOs. A plan that merely provides that the number of shares that may be issued as ISOs under the plan may not exceed a stated percentage of the shares outstanding at the time of each offering or grant under such plan does not satisfy this requirement.
• The plan must also specify the employees or class of employees who are eligible to participate in the plan.
• The shareholders of the company must approve the stock option plan within 12 months before or after the date the plan is adopted. Shareholder approval must comply with all applicable provisions of the corporate charter, bylaws and applicable state law(s) prescribing the method and degree of stockholder approval required for the issuance of corporate stock or options. If state law does not prescribe a method and degree of stockholder approval in such cases, an equity plan that purports to include ISOs must be approved by either:
  • A majority of the votes cast at a duly held stockholders’ meeting at which a quorum representing a majority of all outstanding voting stock is present and voting (either in person or by proxy).
  • A method and degree adequate under state law for actions requiring stockholder approval.

If any of the above conditions are not satisfied with respect to the plan, then any options granted pursuant to such plan will be treated as NQSOs.