Stock Option Fundamentals

Originally published September 7, 2002

Although the decline in the stock market boom has made stock options less profitable for executives than they were in the past decade, they nonetheless remain a widely used and significant form of compensation. This article discusses the basic structure of stock option plans, the tax and accounting rules that apply to incentive and non-statutory stock options and employee stock purchase plans, and developments that could affect such arrangements in the future.

Introduction

The use of stock options as a compensation tool expanded dramatically over the past decade. For example, one commentator noted that the number of employees receiving stock options grew from about 1 million in the early 1990s to between 7 to 10 million in 2002.i This past decade also saw an expansion of options grants to a larger number and broader class of employees; unlike the past when options were primarily offered to a small number of top executives or directors.

Although options were more attractive to executives during the stock market boom than today, they remain a common form of executive compensation. There are still corporate, tax and accounting reasons to offer stock options as compensation. But the recent collapse of Enron Corporation has also focused attention on the "cost" of options to shareholders, and prompted calls for more specific disclosures regarding the value of options granted.

It is important for benefits professionals to understand the changing trends affecting stock options so that they can respond to management, employee, and now, potentially, shareholder inquiries about option plans and alternatives. This article describes the basic structure of three widely used option arrangements - non-statutory stock options, incentive stock options (ISOs) and employee stock purchase plans (ESPPs), as well as the tax consequences of such plans and recent proposals regarding their accounting and required disclosure.

Structure of Option Plans

In General

Option plans offer the optionee the right to buy shares of a company at a set price (the "exercise" or "strike" price). Non-statutory stock options, ISOs and ESPPs differ primarily in their tax consequences and the tax rules defining the options. As discussed below, ISOs and ESPPs are perceived as enjoying better tax results for the optionees, but the "price" of those advantages is decreased flexibility in the form of rules governing the structure of those plans. Non-statutory stock options, as their name implies, are not subject to as many rules regarding their structure, but have fewer tax advantages.

Almost all options are issued pursuant to an option plan. Option plans are often approved by shareholders. Non-statutory stock option plans may or may not require approval depending on the applicable securities laws. Employee stock purchase plans (ESPPs) and plans offering incentive stock options (ISO plans) must be approved by shareholders within 12 months before or after the date the plan is adopted in order to receive special tax benefits.

Option plans generally specify the type of options permitted and the number of shares subject to the option. They are usually administered by an individual or, more likely, a committee, appointed by the Board of Directors. The committee often determines, among other matters, (1) the employees who qualify for eligibility, (2) the type of grant, if any, each employee will receive, (3) the number of shares subject to each option, (4) the time these options can be exercised (the option's "vesting date"), (5) the duration of the exercise period, and (6) the manner in which the option is exercised. These factors are usually set out in an option agreement singed by the company and employee. As noted below, some of these determinations are limited by statutory requirements. ESPPs generally offer uniform benefits to participants. Subject to the statutory requirements for ISOs, option terms under ISOs and non-statutory stock option plans can differ among optionees.

Specific Statutory Requirements for ESPPs and ISO Plans

Options offered under ESPPs and ISOs must meet certain requirements.

ESPPs

As its name implies, ESPPs give employees an opportunity to purchase employer stock through a formal plan. (Sometimes rights under an ESPP are called purchase rights rather than options but the economic effect is the same.) The requirements for ESPPs are set forth in Section 423 of the Internal Revenue Code (Code).

Options under an ESPP can only be offered to employees. Subject to the limits described below, an ESPP must, by its terms, be offered to all employees of a corporation that offers the purchase rights to any employee. Certain exclusions are permitted. The ESPP may exclude employees with fewer than two years of service, or those whose customary employment is 20 hours or less a week, or those whose customary employment is not for more than 5 months in a calendar year. Also, officers, supervisors, or highly compensated employees may be excluded.ii

Although this "universal availability" requirement for ESPPs seems straightforward, it sometimes is not. For example, Microsoft Corporation offered an ESPP to its employees. After the IRS conducted an unrelated payroll audit of Microsoft and Microsoft agreed to reclassify some of its independent contractors as employees for withholding tax purposes, the independent contractors sued Microsoft, arguing that they were "employees" for all purposes, including participation in the ESPP. The contractors were successful in arguing that they should be included in the ESPP and entitled to purchase the benefits of a retroactive purchase of Microsoft stock, which had appreciated significantly, at the then purchase price. The case involving the Microsoft ESPP was eventually settled, using a formula approach to determine how much each contractor should receive in lost profits.iii

By its very nature, then, an ESPP results in widespread ownership of the employer, and such plans are only adopted by employers who want to promote that goal as an employee incentive. Moreover, due to the valuation, accounting and recordkeeping requirements that apply to a program covering such a large number of people, ESPPs are usually offered by large, publicly traded companies.

Options under an ESPP cannot be granted to a participant in the ESPP if, immediately after the option is granted, he would own 5% or more of the total voting power of all classes of stock of the employer. All optionees must have the same rights and features except that options may be granted in different amounts based on a uniform relationship to compensation. For example, a plan could state that the maximum amount of stock that can be purchased is 5 shares per $100 of gross income.

There are also limits on the exercise price, timing of exercise, and the number of shares that can be purchased under an ESPP. Options can only be exercised by the recipient during his or her life, and cannot be transferred. The exercise price cannot be less than the lesser of (i) the fair market value at the time the option is granted, or (ii) an amount that under the terms of the option cannot be less than 85% of the market value at the time the option is exercised. The option must generally be exercised not later than 27 months after the grant date, although if the plan is providing that the exercise price may be less than 15% of the fair market value at exercise, that period extends to five years.

The plan must provide that no employee may purchase stock whose value exceeds $25,000 in a year, based on the fair market value at the time the option is granted for each calendar year under which the option is granted. This is a cumulative limit. For example, if the fair market value at grant is $100 per share, and no shares are purchased in 2002, 500 shares may be purchased in 2003.

Incentive Stock Options

Incentive stock options must also meet certain requirements, which are set forth in section 422 of the Code. They must be offered pursuant to a plan adopted by the employer that meets certain terms...