Equity Compensation
in brief
Frequently Asked Questions
What is a stock option?
It is the right to purchase stock at a specified price.
Why are stock options used?
Stock options provide a performance-based incentive to an employee on a tax-advantaged
basis. Further incentives can be created with the use of a vesting schedule which will
require future performance by an employee before an option is earned.
What are the two types of stock options?
Stocks options either qualify as incentive stock options, or they are nonqualified stock
options.
Frequently Used Terms
Exercise
Paying the exercise (or strike) price of the stock option and taking possession of the stock.
Exercise Price
Also known as the strike price, it’s the amount the employee must pay to exercise the
option.
Grant
The transfer of the stock option to the employee.
Spread
The difference between 1) the fair market value of the stock on the date the stock option is
exercised and 2) the exercise price.
Vesting Schedule
The dates on which the stock options are no longer subject to a risk of forfeiture.
Incentive Stock Options (ISO)
Employee Taxation
• At grant of option – NO.
• At exercise of option – NO.
• Upon sale of stock – YES. The employee is taxed on the gain at the long term
capital gains rate. The gain is gross proceeds minus tax basis, where “gross
proceeds” is the sale price of the stock and “tax basis” is the price the employee
paid for the stock (i.e., the exercise price).
Example:
On January 1, 2007, Employee is granted the option to purchase 1,000 shares of XYZ,
Inc., at $20 per share. On February 1, 2009, when XYZ, Inc. is trading at $35, Employee
exercises 1,000 shares for $20,000. On March 1, 2010, when XYZ is trading at $45,
Employee sells the 1,000 shares of XYZ.
01/01/2007
Grant: 1,000 shares XYZ @ $20/share
02/01/2009
Exercise: 1,000 shares XYZ @ $20/share
when stock is trading @ $35/share
03/01/2010
Sale: 1,000 shares XYZ @ $45/share
$45,000
Gross Proceeds
$45,000
Minus: Tax Basis
$20,000
Equals: Long-term Capital Gain
$25,000
$20,000
Alternative Minimum Tax (AMT)
Although the difference between the fair market value at exercise and the exercise price is
not taxable for regular tax purposes, it is taxable for AMT purposes. A credit is available
to offset future regular income, and will probably be used in the year the stock creating the
AMT liability is sold.
Incentive Stock Options (ISO)
ISO Requirements
If any of these requirements is not met, the option is a Non-qualified Stock Option (see below).
• The shares of stock purchased may not be sold within:
- 2 years of the option grant; and,
- 1 year of the transfer of the share of stock to the employee
• An ISO is not transferable during life.
• The employee cannot own more than 10% of the corporation’s voting power
at the time of grant.
• The FMV of stock subject to the ISO cannot exceed $100,000 in any year,
determined at the time of grant.
• Participants must be employees, and ex-employees have 3 months to exercise.
Employee’s Estate and Heirs
• The tax treatment for an estate or heir is the same as it is for an employee,
except that there are no ISO holding period or employment requirements,
and the ISO receives a step-up in basis.
Employer
• There is no employer income tax deduction. If the ISO is later disqualified (e.g., by
selling stock within one year of exercise), then a compensation deduction may be
available under the Non-qualified Stock Option rules.
Transfer Taxation and Charitable Giving
• An ISO cannot be transferred during life.
• An ISO may be transferred at death, and the valuation for estate tax purposes is
based on a formula.
Non-Qualified Stock Options (NSO)
Employee Taxation
• At grant of option – NO.
• At exercise of option – YES, unless the stock is not vested. The excess of the fair
market value (FMV) at the date of exercise over the exercise price is treated as
compensation to the employee.
• Upon sale of stock – YES. The employee is taxed on the gain measured by gross
proceeds minus tax basis, where “gross proceeds” is the sale price of the stock.
“Tax basis” is the price the employee paid for the stock plus the income reported
at exercise (e.g., the exercise price plus spread at exercise).
Example:
On January 1, 2007, Employee is granted the option to purchase 1,000 shares of XYZ,
Inc., at $20 per share. On February 1, 2009, when XYZ, Inc. is trading at $35, Employee
exercises 1,000 shares for $20,000. On March 1, 2010, when XYZ is trading at $45,
Employee sells the 1,000 shares of XYZ.
01/01/2007
Grant: 1,000 shares XYZ @ $20/share
02/01/2009 Exercise: 1,000 shares XYZ @ $20/share
when stock is trading @ $35/share
$20,000
03/01/2010
$45,000
Sale: 1,000 shares XYZ @ $45/share
FMV at Exercise
$35,000
$20,000
Minus: Exercise Price
Equals: Ordinary Income
$15,000
Gross Proceeds
Minus:Ordinary Income
$15,000
$20,000
Exercise Price
Tax Basis:
Equals: Long-term Capital Gain
$45,000
$35,000
$10,000
Non-Qualified Stock Options (NSO)
NSO Requirements
• If an option is not an ISO, it is an NSO.
• An ISO may become a NSO if it fails to meet the ISO requirements after grant.
Employee’s Estate and Heirs
• The tax treatment for estates and heirs is the same as it is for an employee, with the
income treated as income in respect of a decedent (IRD).
Employer
• When the employee exercises the option the employer can take a compensation
deduction equal to the excess of the FMV at exercise over the exercise price.
Transfer Taxation
• The FMV of a gift is determined by formula. The recipient pays the exercise price,
but the employee pays income tax on the spread at exercise.
• Valuation for estate tax purposes is based on formula.
Charitable Giving
• For gifts during life, the employee will get an income tax deduction equal to the
FMV of the NSO, based on a formula.
• For gifts at death, the NSO is included in the employee’s estate. The estate receives
an estate tax charitable deduction equal to the FMV, based on a formula. A
charity will not pay income tax when it exercises the option because it is taxexempt.
Tax Anatomy of Shares Purchased
ISO Share
Sale Price
FMV at
Exercise
NQ Share
$45
$45
$35
$35
AMT
Adjustment
Exercise Price
$20
Tax Basis
$20
Capital Gain
Ordinary Income
and Tax Basis
Tax Basis
Tax Basis
Restricted Stock
Income Taxation
• At grant – NO. No tax if subject to a substantial risk of forfeiture (i.e., not vested)
and is non-transferable.
• At vesting – YES. The fair market value (FMV) of the stock is income to the
employee. Dividends on restricted stock can be paid during the nonvested period
and are subject to income tax.
• Upon gift of stock – NO. No tax at the time of the gift, but the employee recognizes compensation income on the FMV when the restrictions lapse.
• If the employee dies or becomes disabled owning restricted stock, unmet restrictions might mean stock must be returned to the employer, or plan may allow
employee to keep it.
• If death meets the requirements to lift the restrictions, the FMV is IRD and the
heirs or estate will owe income taxes.
• The employer gets a compensation deduction for the stock when, and in the same
amount as, the income on the stock is reported.
Transfer Taxation
• During life the gift tax value is the FMV of the stock, although the restrictions may
cause a discounted value or even incomplete gift. Gift tax treatment of restricted
stock is unclear—gifts normally not permitted under the plan anyway.
• At death the FMV of the stock is included in the employee’s estate.
Charitable Giving
• Gifts during life result in a discounted value for income tax deduction purposes
and recognition of income upon vesting by the employee. This generally makes
them a poor choice for charitable giving.
• Bequests at death might make sense because a tax-exempt entity will not pay
income tax on the IRD. The stock is included in employee’s estate, but will be
offset by an estate tax charitable deduction.
Net Unrealized Appreciation (NUA)
Income Taxation
• At grant – NO. The employer’s contribution of employer stock to the employee’s
qualified plan is not taxable income.
• At distribution from retirement plan – YES, partially. The basis in the employer
stock is subject to ordinary income tax. The appreciated amount between fair
market value (FMV) and tax basis is NUA, and is not subject to income tax at
distribution.
• Upon sale of stock – YES. The employee is taxed on the NUA at the long term
capital gains rate. Gain in excess of the NUA is taxed at long or short capital gains
rates, depending on how long the stock was held after distribution.
• In order to receive favorable tax treatment of NUA, distributions must be a lump
sum.
• NUA is taxable to the estate and heirs as income in respect of a decedent (IRD).
• Although the NUA is IRD and does not get a step-up in tax basis, any gain in
excess of the NUA does get a step-up.
Transfer Taxation
• The gift is equal to FMV on the date of the gift.
• The FMV of the stock is included in the employee’s estate at death.
Charitable Giving
• As with any stock, the income tax deduction for a lifetime gift is based on FMV.
The charity doesn’t pay tax when it sells the stock, so the NUA is never taxed.
• At death, an estate tax charitable deduction is available. The NUA is IRD, but
charities do not pay tax on IRD.
This document was prepared by the Advanced Planning Division of The Northwestern Mutual Life Insurance Company. Although the
information contained in this document is believed to be accurate, this document is not intended as a primary or substitute resource for
evaluating the relevant legal, tax or accounting principles related to the topic(s) addressed. Judicial and administrative interpretations
of existing laws and regulations, and the actual tax and accounting laws, rules and regulations are subject to change, and Northwestern
Mutual cannot predict whether, how and when such changes might occur. Northwestern Mutual’s publication of this document is not
intended to provide legal, accounting or tax services or advice, and should not be relied on as such. Individuals must rely upon their
own legal, accounting or tax advisors to consider and apply these principles to specific situations and transactions.
– To comply with Circular 230 MDRT IR Index 4000.00
The Northwestern Mutual
Life Insurance Company • Milwaukee, WI
www.northwesternmutual.com
22-4374 (1006) (Rev. 0807)