Effect of New Capital Gains Rates on Stock Options

CPA Journal, The, May 1998 by Geller, Sheldon M, Neumark, Avery E, Haller, Peter E

Should companies grant incentive stock options, instead of nonqualified stock options, now that the maximum tax rate on long-term capital gains has been reduced? Many companies are asking this question.

Under the 1997 tax legislation, as a general rule, an individual's short-term capital gains (gains from the sale of assets held for one year or less) are taxed at ordinary income tax rates, gains from the sale of assets held for more than one year but not more than 18 months are taxed at a maximum rate of 28%, and long-term capital gains (gains from the sale of assets held for more than 18 months) are taxed at a maximum rate of 20%. The reduced rates make incentive stock options (ISOs) even more valuable to employees than was previously the case.

An employee does not recognize income when an ISO is exercised (except that the ISO "spread" is taken into account for alternative minimum tax purposes). Instead, the employee recognizes income when the stock is sold. If the employee holds the stock acquired upon the exercise of an ISO for at least two years from the date of grant and one year from the date of exercise, the gain will be taxed as capital gain. Under the new law, if the sale occurs more than 18 months from the date on which the option is exercised, the gain will be taxed as longterm capital gain at a maximum 20% rate. If the holding period requirements are met but the employee sells the stock between 12 and 18 months after the option is exercised, the gain will be taxed at a maximum 28% rate. The company generally has no tax deduction with respect to an ISO (unless the holding period requirements are not met).

In contrast, when an employee exercises a nonqualified stock option, the employee recognizes ordinary income equal to the option "spread." The company generally receives a corresponding income tax deduction.

Since the company generally receives no tax deduction with respect to an ISO, ISOs are more costly to a company than nonqualified options. On the other hand, the combination of postponed tax and favorable long-term capital gain rates make ISOs very favorable to the employee.

Some companies view the tax benefits to employees (or at least selected employees) as more important than the tax benefits to the company and so are granting ISOs. Other companies consider the tax benefits to the company to be more important and are granting nonqualified options. Companies can increase the number of nonqualified options to take into account the less favorable tax consequences to the employee, or they can grant an employee a nonqualified option with a supplemental cash bonus structured to compensate the employee for the increased tax cost. The accounting consequences of such a cash bonus should be considered. We expect that companies will continue to choose between ISOs and nonqualified options, or use a combination of the two, depending on the company's objectives for the particular options and the tax cost to the company.