Many companies use equity compensation to attract potential employees and to reward and retain existing employees.  A brief overview of two typical equity compensation plans, the stock option plan and the restricted stock purchase plan, is provided below.  Sometimes the features of a stock option plan and a restricted stock purchase plan are combined into a single stock plan.

Stock Option Plan

A stock option is the contractual right to purchase shares of a company’s stock at a specified price during a specified period.  An option is granted with a vesting schedule (typically 4 years) and an exercise price that is generally equal to the fair market value of the stock at the time of the grant.  Once the option vests, the option holder can exercise the option at any time until the option expires (generally 10 years after the option is granted).  If the option holder chooses to exercise the option and purchase the stock, and the fair market value of the stock at the time of exercise is higher than the exercise price of the option, then the option holder benefits from the increase in such value by being able to purchase the stock at a price lower than the stock’s then fair market value. 

There are two types of stock options a company can grant, an Incentive Stock Option (“ISO”) and a non-statutory stock option (“NSO”). An ISO can only be granted to employees whereas a NSO can be granted to anyone (employees, consultants, directors, etc.)  The two types of options are treated differently for income tax purposes.

If certain requirements are met, income is not recognized upon the exercise of an ISO, but only upon the subsequent resale of the stock.  If these requirements are met, when the stock is sold, the option holder is taxed on the difference between the exercise price paid by the option holder and the subsequent sale price of the stock. In general, if an option holder exercises an ISO and holds the stock for at least one year before reselling, any gain (or loss) on the subsequent sale of the stock is treated as long-term capital gain (or loss).  However, when an ISO is exercised, the excess of the fair market value of the shares over the exercise price (often referred to as the “spread”) will be included in alternative minimum taxable income.

In contrast, income is recognized upon the exercise of a NSO rather than upon the subsequent sale of the stock.  If the fair market value of the stock at the time of the exercise is higher than the exercise price, the option holder immediately recognizes a gain and incurs a tax liability (at ordinary income tax rates) upon the exercise of the option.

Restricted Stock Purchase Plan

A stock purchase plan involves the actual purchase of the stock, and differs from an option, which is only the right to purchase stock.  The most common type of stock purchase plan is a restricted stock purchase plan, which allows stock recipients to purchase stock subject to the right of the company to buy back the unvested portion of the restricted stock from the restricted stock recipient at the original purchase price.  The right of the company to repurchase the unvested stock typically is triggered upon the occurrence of certain events (e.g., termination of employment), and lapses over time.

Generally, a restricted stock recipient can minimize tax liability by filing an election under Internal Revenue Code Section 83(b).  Under the tax code, a restricted stock recipient generally recognizes income upon the vesting of the stock and incurs tax liability on the difference between the fair market value of the stock at the time of vesting and the original stock purchase price.  If, however, the restricted stock recipient makes a timely 83(b) election, income is recognized at the time of the stock purchase rather than upon the vesting of the stock, and the one year capital gain holding period begins on the date of the stock purchase rather than upon the vesting of the stock.  If a restricted stock recipient subsequently sells the stock more than one year after the original stock purchase date, any difference between the original stock purchase price and the fair market value of the stock at the time of the subsequent sale is taxed as capital gain (or loss) and not as ordinary income.