1 Review: Restricted property, Nonqualified stock options, Incentive options. Howard Godfrey, Ph.D., CPA UNC Charlotte Copyright © 2008, Dr. Howard Godfrey Edited November 10, 2008.

Restricted Stock Value not taxed until stock vests – Employee recognizes ordinary income = FMV of stock when vested – Dividends taxed as ordinary income prior to vesting Election to accelerate income made by recognizing income = FMV in year of receipt – No deduction for loss if forfeited

In what year does the employee first recognize income? 2002 How Much? $180 How much income is recognized when the stock is ultimately sold? $120

Restricted Stock-Luis-1 Luis received 400 shares of his employer’s stock as a bonus. He must return the stock if he leaves before the 5-year vesting period ends. The FMV of the stock at the time it was issued was $20,000. After five years, the stock vests when it has a FMV of $75,000. Two years after vesting, Luis sells the stock for $100,000.

Restricted Stock-Luis-2 a. If Luis makes no election, how much income or gain does he recognize (1) when the stock is issued, (2) when the stock vests, and (3) when the stock is sold? b. If Luis makes an election to accelerate the recognition, how much income or gain does he recognize (1) when the stock is issued, (2) when the stock vests, and (3) when the stock is sold?

Restricted Stock-Luis-3 a. (1) zero; (2) $75,000; (3) $25,000. Luis will not recognize any income until the stock vests. Upon vesting, Luis will have ordinary income equal to the fair market value at that time. In this case, Luis will have $75,000 of ordinary income in the year the stock vests. When he sells the stock, Luis will recognize a capital gain of $25,000.

Restricted Stock-Luis-4 b. (1) $20,000; (2) zero; (3) $80,000. If Luis makes an election to accelerate the recognition of income, he will recognize the fair market value of the stock as income in the year of receipt. His ordinary income in the first year would be $20,000. There is no recognition of income or gain when the stock vests. Upon sale of the stock, Luis will recognize a capital gain of $80,000.

Stock Options A stock option is the right to buy a share of stock at a fixed price within a specified period of time or on a specified date. Options have three important dates Grant date: the date an employee gets the option. Exercise date: the date the employee trades the option for stock. Sale date: the date the employee sells the stock.

Stock Options There are two kinds of stock options – Nonqualified stock options Tax treatment depends on whether the option has a readily ascertainable fair market value – Incentive stock options No tax consequences until the sale date

Nonqualified Stock Options With Ascertainable FMV At the grant date (assume no contingency) – Employee has ordinary income = FMV of option – Corporation has deduction = income recognized At the exercise date – Employee basis in the stock = exercise amount paid + income recognized – Holding period begins At the sale date – Employee has capital gain = sales price less basis

Nonqualified Stock Options With No Ascertainable FMV FAt the grant date VNo tax consequences FAt the exercise date (assume stock vests here) VEmployee has áOrdinary income = FMV of stock - exercise price paid, and áBasis in stock = exercise price paid + income áHolding period begins VEmployer has deduction = income recognized FAt the sale date VEmployee has capital gain = sales price less basis

Nonqualified Stock Options Substantially Restricted FAt the grant date - No consequences FAt the exercise date VWhen restrictions lapse, employee has áOrdinary income = FMV - exercise price áBasis in the stock = exercise amount paid + income áHolding period begins VEmployer has deduction = income FAt the sale date VEmployee has capital gain = sales price less basis FConsequences of grant and exercise date may be reversed with Sec. 83(b) election

Incentive Stock Options (ISO) Requirements for ISO treatment – Must be part of a qualified stock plan – Option must be exercised within ten years of date of grant – Option price must be > FMV of the stock at date of grant – Option cannot be transferable – FMV of the ISOs granted in a year cannot exceed $100,000

Incentive Stock Options Tax consequences – No consequences on grant or exercise dates – At the exercise date Employee has basis in stock = amount paid – At the sale date Employee has capital gain = sales price less basis – Employer never has deduction

Stock Options Option – right to purchase stock at strike price for a specific time Grant date – date option offered to individual Exercise date – date option used to purchase stock Bargain element – difference between strike price and FMV of stock

Nonqualified Stock Options Employee recognizes ordinary income equal to the bargain element on the date the NQSO is exercised – Employer gets matching compensation deduction for bargain element – Employee’s basis for stock is cash paid + income recognized

On , an employee receives an option to purchase 1,000 shares of his employer’s stock for $100 per share. (Pretend options are traded and worth $10 each.) The shares are worth $110 per share on January 1, The option can be exercised on January 1, 2001.

On , the value is $150 per share. On , the employee buys 1,000 shares at $100 per share. If employee sells stock prior to , he must sell it back to the company at $100 per share. On , the restrictions lapse. On , the stock has a value of $180 per share. He will later sell the stock for $300 per share on

1. If an election under Section 83(b) is made, how much income will he recognize prior to the year in which the stock is ultimately sold? a. -0- b. $10,000 c. $50,000 d. $80,000 e. $200, If no Section 83(b) election is made, what is the first year in which he will be required to report income? a b c d. 2003

3. If no Section 83(b) election is made, how much income will he recognize prior to the year of sale? a. $0 b. $50,000 c. $ 80,000 d. $150,000 e. $200, If no Section 83(b) election is made, what gain will be reported when the stock is sold in 2003? a. $0 b. $50,000 c. $ 80,000 d. $120,000 e. $200,000

Incentive Stock Options ISOs provide more favorable treatment for employee – ISOs do not trigger any income recognition at the date of grant or exercise – Income is recognized only upon the sale of the stock, usually as long-term capital gain – But bargain element is an individual AMT adjustment Employer receives no compensation deduction

Phantom Stock Phantom stock plan - deferred compensation is hypothetically invested in shares of company’s stock – At the end of deferral period (such as at retirement), the employer pays the employee the FMV of the phantom shares

SARs Stock appreciation right (SAR) plan - employees are given the right to receive a cash payment equal to the appreciation in value of employer’s stock for a certain period of time – Employees recognize income only when they exercise their SARs

Adjustments Non-Statutory Stock Options- Regular Tax [How Much] Excess of FMV over exercise price. [When for regular tax] in year stock is freely transferable or not subject to substantial risk of forfeiture.

Adjustments Incentive stock options (ISOs) for AMT For Regular Tax- No tax until stock is sold For AMT- Bargain element is AMT adjustment. [How Much] Excess of FMV over exercise price is adjustment [When] in year of exercise.

Nonstatutory Stock Option Given nonstatutory option – 1 share at $100/share. [FMV is $100/share] Option exercised. Value is $150/share Buys 1 share at $100/share Sells stock for $300/share. For income tax purposes, the individual reports gain or $50 in Stock basis becomes $150.

Incentive stock option Given Incentive option for 1 share at $100/share. [FMV is $100/share] Option exercised. Value is $150/share Buys 1 share at $100/share Sells stock for $300/share. For income tax, the report no gain until Stock basis is $100. Gain is $200 in For AMT, recognize $50 as AMT adjustment in 2001 and stock basis for AMT becomes $150. Negative AMT adjustment to taxable income of $50 to get AMTI in 2003.

Incentive Stock Options-Netcom-1 Three years ago, Netcom granted an ISO to Karen to buy 2,000 shares at $6 per share exercisable for 5 years. At the date of the grant, Netcom stock was selling for $5 per share. This year, Karen exercises the ISO when the price is $30 per share. a. How much income should Karen have recognized in the year the ISO was granted?

Incentive Stock Options-Netcom-2 b. How much income does Karen recognize when she exercises the ISO? c. What are the tax consequences for Netcom from the ISO in the year of grant and in the year of exercise? d. What are the tax consequences to Karen and to Netcom if Karen sells all of the stock for $50 per share two years after exercising the options?

Incentive Stock Options-Netcom-3 a. Zero. No income is recognized when the option is granted. b. Zero. No taxable income when the option is exercised (however, the bargain element is subject to the AMT).

Incentive Stock Options-Netcom-4 c. Zero. No tax consequences for Netcome in the year of grant or exercise. d. Karen has an $88,000 capital gain [($50 selling price - $6 cost) x 2,000 shares]. Netcom receives no tax deduction and thus no tax benefit.

Stock Appreciation Rights Four years ago, Handcock Corporation granted 300 SARs to Maria as a bonus. Handcock's stock was worth $20 a share on the date of grant. Maria exercises her SARs this year when the stock is worth $60 a share. a. How much income should Maria have recognized in the year she received the SARs?

Stock Appreciation Rights b. How much income does Maria recognize when she exercises the SARs? c. If Maria is in the 35 percent marginal tax bracket, what is her after-tax cash flow from the exercise of the SARs? d. Does Handcock Corporation get a tax deduction for the SARs and if yes, when and in what amount?

Stock Appreciation Rights a. Zero. No income when the SARs are granted. b. $12,000 income recognized when she exercises the SARs. [($60 - $20) x 300 SARs]