Stock Options Chapter 35 Employee Benefit & Retirement Planning Copyright 2011, The National Underwriter Company1 A formal, written offer to sell stock at a specified price, within specified time limits –granted as additional compensation with expectation stock value will rise –gives executives advantages of business ownership Two types of stock options are typically used to compensate executives: –incentive stock option plans (ISOs) –nonstatutory stock options What is it?

Stock Options Chapter 35 Employee Benefit & Retirement Planning Copyright 2011, The National Underwriter Company2 Desirable because –expect stock value will rise, allowing gain on spread between option and market price –can defer tax to when stock purchased –gives executives ownership in the business What is it?

Stock Options Chapter 35 Employee Benefit & Retirement Planning Copyright 2011, The National Underwriter Company3 1.Employer willing to share business ownership 2.Employer wants to reward executive performance with compensation that increases in value as the employer stock increases in value When is it Indicated?

Stock Options Chapter 35 Employee Benefit & Retirement Planning Copyright 2011, The National Underwriter Company4 1.Flexible plan design and few tax or governmental regulatory constraints 2.Little to no out-of-pocket cost for company 3.Employee can defer tax until exercise option or later if combine option with nonqualified deferred compensation arrangement Advantages

Stock Options Chapter 35 Employee Benefit & Retirement Planning Copyright 2011, The National Underwriter Company5 1.Executive bears market risk on stock option 2.Executive must have source of funds for stock purchase 3.Market price of stock may have little relationship to executive performance 4.Employer tax deduction usually delayed until executive exercises stock option Disadvantages

Stock Options Chapter 35 Employee Benefit & Retirement Planning Copyright 2011, The National Underwriter Company6 Option has no readily ascertainable fair market value at time granted: 1.Executive has no taxable income at date of grant 2.When shares purchased, the ‘bargain element’ is treated as ordinary income and taxed accordingly Tax Implications

Stock Options Chapter 35 Employee Benefit & Retirement Planning Copyright 2011, The National Underwriter Company7 Option has no readily ascertainable fair market value at time granted: 3.Employer’s tax deduction taken when option exercised and is equivalent to employee taxable income from the exercise of the option 4.Executive’s basis in the shares = amount paid for the stock + amount of taxable income reported by the executive when option exercised Tax Implications

Stock Options Chapter 35 Employee Benefit & Retirement Planning Copyright 2011, The National Underwriter Company8 Option has readily ascertainable fair market value –Employee Taxed at time of grant –Employer received at time of grant –Employee has no further taxable compensation income when option later exercised Tax Implications

Stock Options Chapter 35 Employee Benefit & Retirement Planning Copyright 2011, The National Underwriter Company9 1.Stock options are often used by closely held corporations as a way to reward executives. 2.Stock options are a form of compensation with little to no out-of-pocket costs to the company 3.The company bears investment risk when granting a stock option to an executive. True or False?

Stock Options Chapter 35 Employee Benefit & Retirement Planning Copyright 2011, The National Underwriter Company10 4.Tax laws are the same whether or not company stock has a readily ascertainable fair market value at the time that it is granted. 5.An option has readily ascertainable fair market value if it has a value that can be determined as of time of the grant and the option can be traded on an established market. True or False?

Stock Options Chapter 35 Employee Benefit & Retirement Planning Copyright 2011, The National Underwriter Company11 What is the effect of federal securities laws on stock option plans? Discussion Question