Ch. 12 LO-2 DQs

Why do employers use stock options in addition to salary to compensate their employees? For employers, are stock options treated more favorably than salary for tax purposes? Explain

Because stock options reward employees for making choices that increase the share price of the corporations where they are employed, this form of compensation is considered to be superior to salary in terms of motivating employees to behave more like owners—stock options align the incentives of employees and owners. In addition, employers may use stock options to compensate their employees without a cash outlay. Employers also use stock options to circumvent the $1 million §162(m) deduction limitation on non-performance based salary payments to key executives because options are considered to be a form of performance-based pay. Other than this advantage, there is no other tax advantage to using options over regular salary to compensate employees, because, at best, the bargain element from options exercises provides an ordinary deduction for employers in the year of exercise.

How is the tax treatment of restricted stock different from that of nonqualified options? How is it similar?

Employees with nonqualified options are taxed at ordinary rates on the bargain element of the shares received on the date of exercise. In contrast, employees receiving restricted stock are taxed at ordinary rates on the fair market value of the shares on the date the restricted stock vests. The tax treatment of the two is similar in that both are taxed at ordinary rates.

Matt just started work with Boom Zoom, Inc., a manufacturer of credit card size devices for storing and playing back music. Due to the popularity of their devices, analysts expect Boom Zoom's stock price to increase dramatically. In addition to his salary, Matt received Boom Zoom restricted stock. How will Matt's restricted stock be treated for tax purposes? Should Matt consider making the section 83(b) election? What are the factors he should consider in making this decision? From a tax perspective, would this election help or hurt Boom Zoom?

If Matt doesn't make the §83(b) election, the fair market value of the stock on the vesting date will be included in Matt's salary income in the year the stock vests. Boom Zoom, Inc. will take a corresponding ordinary deduction in the same year Matt includes the value of the stock in his salary. If Matt makes an §83(b) election, he will include the fair market value of the stock on the grant date in his salary income in the year of grant and Boom Zoom will take a deduction of the same amount as compensation expense in the year of grant. Matt should consider making this election to accelerate income if the current stock price of Boom Zoom is small relative to his expectation of the future share price of Boom Zoom. Under these conditions, the current tax Matt pays now will pale in comparison to the tax savings generated by converting the appreciation in share price from the grant date to the vesting date into capital gain. However, an §83(b) election under these conditions would be detrimental to Boom Zoom because its salary deduction, although accelerated, will be much smaller at the same before-tax cost.

What risks do employees making an §83(b) election on a restricted stock grant assume?

If, after making an §83(b) election, the market value of the restricted shares stays flat (or declines), employees will have accelerated a tax payment without receiving the benefit of converting what would otherwise have been ordinary income into capital gain. Moreover, if the restricted stock doesn't become vested subsequent to the §83(b) election, employees will have reported income that they did not actually receive (phantom income).

From an employer perspective, how are incentive stock options treated differently than nonqualified stock options for tax purposes? In general, for a given number of options, which type of stock option should employers prefer?

In contrast to nonqualified options, employers never receive a deduction related for incentive stock options. Thus, employers generally prefer (unless the employer's marginal rate is 0 percent) nonqualified options over an equivalent number of incentive stock options

What is a "disqualifying disposition" of incentive stock options, and how does it affect employees who have exercised incentive stock options?

In order to receive the favorable tax treatment afforded incentive stock options, employees acquiring shares by exercising ISO's must hold the shares for at least 2 years after the grant date and 1 year after the exercise date. Shares acquired with ISOs and sold prior to meeting these holding period requirements trigger a "disqualifying disposition." Because disqualifying dispositions cause incentive stock options to be treated as nonqualified options for tax purposes, the bargain element is taxed at the time of sale at ordinary rates.

Compare and contrast how employers record book and tax expense for stock options.

Under ASC 718, employers expense the economic value of option grants (determined on the grant date) ratably over the vesting period for book purposes for both incentive and nonqualified stock options. For tax purposes, employers expense the bargain element when nonqualified options are exercised. However, employers never receive a tax deduction for incentive stock options.

From an employee perspective, how are incentive stock options treated differently than nonqualified stock options for tax purposes? In general, for a given number of options, which type of stock option should employees prefer?

Unlike nonqualified stock options, the bargain element of incentive stock options is not included in the employee's regular taxable income on the exercise date. Instead, the bargain element present on the exercise date is deferred until the stock acquired from the option exercise is sold. Further, with incentive stock options, the bargain element is treated as long-term capital gain rather than ordinary income when the stock is sold. For these reasons, employees generally prefer incentive stock options over an equivalent number of nonqualified options.