practice of granting a company’s employees options to purchase the company’s
stock has become widespread among American businesses. Employee stock
options have been praised as innovative compensation plans that help align
the interests of the employees with those of the shareholders. They have
also been condemned as schemes to enrich insiders and avoid company taxes.
The tax code recognizes two general types of employee options, “qualified” and
nonqualified. Qualified (or “statutory”) options include “incentive stock
options,” which are limited to $100,000 a year for any one employee, and “employee
stock purchase plans,” which are limited to $25,000 a year for any
employee. Employee stock purchase plans must be offered to all fulltime employees
with at least two years of service; incentive stock options may be confined to officers
and highly paid employees. Qualified options are not taxed to the employee when
granted or exercised (under the regular tax); tax is imposed only when the
stock is sold. If the stock is held one year from purchase and two years
from the granting of the option, the gain is taxed as long-term capital
gain. The employer is not allowed a deduction for these options. However, if
the stock is not held the required time, the employee is taxed at ordinary
income tax rates and the employer is allowed a deduction. The value of
incentive stock options is included in minimum taxable income for the
alternative minimum tax in the year of exercise; consequently, some taxpayers
are liable for taxes on “phantom” gains from the exercise of incentive stock
options. On October 3, 2008, the Emergency Economic Stabilization Act of
2008 (P.L. 110-343) was enacted. This law included provisions that
provided abatement of any taxes still owed on “phantom” gains.
Nonqualified options may be granted in unlimited amounts; these are the options
making the news as creating large fortunes for officers and employees.
They are taxed when exercised and all restrictions on selling the stock
have expired, based on the difference between the price paid for the stock
and its market value at exercise. The company is allowed a deduction for the
same amount in the year the employee includes it in income. They are
subject to employment taxes also. Although taxes are postponed on
nonqualified options until they are exercised, the deduction allowed the
company is also postponed, so there is generally little if any tax advantage to
The following seven key laws and regulations concerning stock options are
described: Section 162(m)—“Excessive Remuneration,” Sarbanes-Oxley Act:
Stock Option Disclosure Reforms, SEC’s 2003 Requirement of Approval of
Compensation Plans, FASB Rule for Expensing Stock Options, American Jobs
Creation Act of 2004 (Section 409A), IRS Schedule M-3, and SEC’s 2006
Executive Compensation Disclosure Rules.
This report explains the “book-tax gap” as it relates to stock options and S.
2075 (Ending Excessive Corporate Deductions for Stock Options Act)
introduced by Senator Carl Levin. U.S. businesses are subject to a dual
reporting system. One set of rules applies when they report financial or “book”
profits to the public. Another set of rules applies when they report taxable income
to the Internal Revenue Service. The “book-tax” gap is the excess of reported
financial accounting income over taxable income.
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