Stock-option plans

In addition to stock-purchase plans and ESOPs, stock options are another way to align a part of your employees' compensation with your firm's financial success.

Stock options are issued, or granted, to key employees as call options. A call option gives the option holder the right (but not the obligation) to buy shares of the underlying stock at an agreed upon price for an agreed-upon length of time. These terms are spelled out in the option agreement.

When employees decide to convert their options to shares, they exercise the options. The price at which they exercise is the exercise price. (Traders refer to the exercise price as the "strike" price.) If the exercise price is higher than the share price, the employee earns a profit. (Profit is reduced by the amount of brokerage fees paid to sell shares on the market.)

If your business is privately held, you can still use stock options. You may intend to sell your shares to the public eventually. If you intend to remain a privately held company, employees can sell their exercised shares to you at a price determined to be a fair market value for your shares.

In general, stock options require employees to vest before they are able to exercise. You spell out the terms of vesting when you grant options. Once vested, the employee generally retains the right to exercise for at least a couple of years. Options are generally issued at a price that is above the current share price, or out-of-the-money.

There are two main types of employee stock options, whose differences relate primarily to tax considerations:

• Incentive stock options. Incentive stock options are stock options that may qualify for tax advantages. Employees do not owe taxes on incentive stock options until they sell the exercised shares. As a result, you do not take a tax deduction for employee-compensation expense.
  
  If the shares are held for at least two years after being granted and one year after being exercised, the employee pays the preferential capital gains rate. If sold sooner, incentive stock options are taxed as ordinary income.
  
  (Note: a drawback of granting incentive stock options is that the employee may be subject to the alternative minimum tax on the amount that is based on the difference in the exercise and grant price.)
  
  For more information on the requirements of issuing incentive stock options, see Section 421(a) of the U.S. tax code. You can find the tax code at the Web site of the Legal Information Institute (LII) of Cornell University.
  
  
• Nonqualified stock options. Nonqualified stock options are taxed as ordinary income when the employee exercises the options. The tax is based on the difference in the exercise and share prices. For example, if the exercise price is $10 and the share price is $12, and the employee exercises options to buy 1,000 shares, the tax is based on $2,000 in income. You can generally deduct this amount as compensation expense.

The following table shows an example of exercising stock options. Assume you grant an employee 10 options that can be exercised for 100 shares each. That gives the employee the chance to hold 1,000 shares if all options are exercised. If the exercise price is $20 and the share price is $12 (or valued at $12), the options are said to be out-of-the-money by $8 a share, or $8,000. If the share price rises to $24, the options are in-the-money $4 a share, or $4,000:

The National Center for Employee Ownership (NCEO) estimates that in 2001 as many as 3 million employees in the U.S. receive stock options annually. The non-profit organization offers additional information on the tax advantages of using incentive stock options.

The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax adviser.