Taxation of Incentive Stock Options (ISOs)
ISOs offer employees a very convenient tax treatment. If all the conditions for ISOs are fulfilled, employees are not taxed when they receive or exercise the options, but only when they sell the shares. When the shares are sold, employees are generally liable for a capital gains tax of 20% if the shares were held for at least two years from the date of grant of the options and at least one year from the date of exercise of the options (in any other case, employees are liable for ordinary income tax according to their respective tax brackets).
For an option to be recognized as an ISO, the following conditions have to be fulfilled:
It should be noted that there is a ceiling of $100,000 for ISO benefits associated with options which are exercisable within one calendar year.
The tax consequence of ISOs is that employees are liable, as mentioned above, for a capital gains tax at the time of sale of the shares.
If an employee sells the shares within two years from the date of award, or within one year from the date of exercise of the option (i.e., its conversion into a share), or if the employee ceases to work for the company, its subsidiary, or parent company during the period from the date of grant of the options until three months before the options are exercised (disqualifying exercise), the employee is then taxed for a portion of the profit as an ordinary income.
With ISOs, the company cannot record the benefit received by the employee as an expense. In the case of a disqualifying exercise of an ISO, the company can deduct the profit for which the employee is taxed as an expense for tax purposes, on the date of payment of the tax by the employee.
Taxation of Non-qualified Stock Options (NSOs)
If the conditions for an ISO are not met, then the options are deemed as NSOs. NSOs are generally awarded as a benefit only to employees and other service providers who cannot be given ISOs.
An employee who receives NSOs is taxed on the date of receipt or exercise of the options. If the market value of the share can be determined (for instance, if the share is publicly traded), then the employee is taxed at the time of receipt of the option. However, if the market value of the share cannot be determined, then the employee is taxed at the time of exercise of the option. In general, the employee is liable for ordinary income tax on the difference between the market value of the share and the exercise price of the option at the time of exercise. Any additional profit after the tax is paid is deemed as a capital gain and the employee is liable for the reduced capital gains tax.
The company may deduct the benefit received by the employee or the service provider, but only up to the amount of the employee's or service provider's ordinary income.
Taxation of Employee Stock Purchase Plans
An ESPP is a compensation plan which provides employees with a special mechanism for buying shares of the company. When the requirements fixed in Sections 422(a) or 423(a) of the Internal Revenue Code are met, the shares are subject to a favorable tax treatment.
In principle, an ESPP enables an employee who is interested in participating in the plan to notify the company to deduct up to 15% of his or her salary during the term of the plan. At the end of the term of the plan, the company buys shares for the employee with the amount accumulated, with a discount of up to 15% on the price of the shares on the date of share purchase, or the price of the shares on the date of commencement of the plan, whichever is lower.
The preferred tax treatment is that if the employee held the shares purchased for two years from the beginning of the term of the plan and for one year from the date of purchase of the shares, then the amount taxed as ordinary income will be the lower of the actual gain or the discount on the purchase price. That is, any increase in value from the date of purchase of the shares until the date of sale of the shares is taxed as a capital gain at the rate of 20%.
The following conditions have to be met for a plan to be recognized as an ESPP: The plan must be approved by the general shareholder meeting; its term cannot be longer than five years; no offeree may hold more than 5% of the share capital; an offeree cannot buy shares for more than $25,000 in one calendar year; the rights under the plan cannot be transferable; the offerees are all employees; and all of the company's employees have to be entitled to participate in the plan, although employees who are employed for less than two years, employees who do not work more than 20 hours per week, employees who do not work more than five months in a calendar year, and highly compensated employees may be excluded from this rule.