On the other hand, an employee may exercise an ISO in the first calendar quarter of a year and hold the stock received for the ISO holding period, then sell it to pay his AMT by April 15 of the following year. Although this may be a wise tax strategy, it also entails a year's worth of market risk if the employee stubbornly holds on to a declining stock to avoid disqualifying the ISO. Further, the early sale of some shares will not disqualify the remainder of the option, so all of the intended benefits of the ISO may not be lost.
Unlike the issuance of restricted stock, which results in a deduction to the corporation in the year the employee recognizes income, no deduction is allowed to the employer with respect to an ISO unless the employee makes a disqualifying disposition of the stock acquired (i.e., sells it before the holding period noted above is satisfied). Because of this loss of deduction for the employer and the relatively small tax advantage for the employee when the alternative minimum tax is considered, ISOs are generally not favored by profitable employers.
The employee who receives a non-statutory or non-qualified stock option generally recognizes ordinary income upon the exercise of the option, equal to the difference between the fair market value and the exercise price of the stock on the date of exercise. Once the option is exercised, the stock received is treated as having been purchased on the date of exercise, and generally any future appreciation is, therefore, eligible for capital gains treatment. In effect, the tax consequences of non-statutory stock options are similar to restricted stock for which a Section 83(b) election has not been made. However, they give the employee more control over the timing of income recognition. Because the recent tax law changes have increased the advantages of converting stock appreciation into a capital gain instead of ordinary income, some employers are granting their employees "reverse vest options" that are exercisable immediately for stock which is subject to vesting, just as restricted stock is. The IRS has agreed that an 83(b) election may be filed upon exercising a non-qualified option and receiving restricted stock.
Conclusion
Companies whose stock has a relatively low value will often find it best to issue restricted stock to employees and have the employees make an election under Section 83(b) of the Code to recognize the income immediately upon grant. This may also be true of companies that can benefit from an immediate compensation deduction, even if the value of their stock is relatively high, perhaps combined with a cash bonus or loan to help the employees granted the stock to pay their taxes. For companies with more than nominal stock value, stock options will continue to be useful to grant employees a larger stake in their employers with no immediate tax consequences to the employees, although with generally less favorable tax consequences in the long run. Most important, employers should be very aware of the rapidly changing equity compensation landscape and be prepared to show their employees that they are familiar with, and considering, all of the appropriate alternatives for equity compensation.
Kenneth E. Werner, a partner in the Hartford office of Day, Berry & Howard LLP, focuses his practice on federal income taxation issues arising in business transactions, employee benefits and executive compensation. He can be reached at [email protected]. Andrea M. Teichman, a partner in the Boston office of Day, Berry & Howard LLP, counsels privately held companies on a variety of issues relating to formation and operations, equity and debt financings and mergers and acquisitions. She can be reached at [email protected].