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Stock option defined: the right to buy stock in the future for a set price (called the exercise price).
General attributes: when the stock option is granted, the option price is the FMV at the date of the grant.
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Stock Options - Grant DateStock Options - Grant Date
GAAP rules: must disclose compensation element due to FMV of option at grant date. Black Scholes option pricing method.
Tax rules: NO tax owed at date of grant. Tax at exercise and sale depends on whether a NonQualified Stock Option (NSO) or Incentive Stock Option (ISO).
Employee has salary income equal to difference in FMV of stock and exercise price.
Employee’s new basis in stock is FMV at exercise date.
Employer gets tax deduction equal to employee income.
When employee sells stock in future, he generates a capital gain (loss) = selling price - basis ($FMV date of exercise).
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NSO ExampleNSO Example
The CFO is granted 100 options (NSOs) in 1998 at a price of $10 per share, when the stock is trading at $10 per share. In 2001, he exercises these shares when the FMV of the stock is $25 per share. In 2004, he sells these shares at $30 per share.
What is the amount, character, and timing of the CFO’s income and the corporation’s deduction? 1998 - no tax effect to either party 2001 - CFO salary income $1,500, salary deduction $1500 2004 - capital gain $500, no company deduction.
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NSO Example (you do it)NSO Example (you do it)
The Treasurer is granted 100 options (NSOs) in 1998 at a price of $10 per share, when the stock is trading at $10 per share. In 2001, she exercises these shares when the FMV of the stock is $30 per share. In 2004, she sells these shares at $28 per share.
What is the amount, character, and timing of the Treasurer’s income and the corporation’s deduction?
Employee has no salary income on exercise. AMT adjustment = untaxed bargain element.
Employer has no salary deduction ever. Exception - early disposition of stock (w/in 2 years of grant or w/in 1
year of exercise).
Employee has basis in stock equal to exercise price When employee sells stock in future, he generates at
capital gain (loss) = selling price - exercise price.
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ISO ExampleISO Example
The CFO is granted 100 options (ISOs) in 1998 at a price of $10 per share, when the stock is trading at $10 per share. In 2001, he exercises these shares when the FMV of the stock is $25 per share. In 2004, he sells these shares at $30 per share.
What is the amount, character, and timing of the CFO’s income and the corporation’s deduction?
1998 - no effect. 2001 - no effect (except AMT) 2004 - $2000 capital gain, no corporate deduction.
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ISO Example (you do it)ISO Example (you do it)
The Treasurer is granted 100 options (ISOs) in 1998 at a price of $10 per share, when the stock is trading at $10 per share. In 2001, she exercises these shares when the FMV of the stock is $30 per share. In 2004, she sells these shares at $28 per share.
What is the amount, character, and timing of the Treasurer’s income and the corporation’s deduction?
Plan cannot be discriminatory; $ limits in law. Salary contributed to plan is not currently taxed
(IRA, 401K, Defined contribution plans). Employer generally gets deduction for funding plan. The plan itself is tax exempt, so earnings are not
taxed as they accumulate. Retiree is taxed on withdrawals of all amounts. Premature withdrawals 10% excise tax
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Tax Advantages of Typical Qualified PlanTax Advantages of Typical Qualified Plan
Formula:{$1 / (1-tp0)} x (1+R)n x (1-tpn)
This means that the dollar after the benefit of the tax deduction in period 0, accumulates for n periods at the before tax rate, then the total is taxed at the rate in period n.
Having a higher rate in the year you contribute (tp0), and a lower rate in the year you withdraw (tpn) makes this worth more.