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Nonstatutory Stock Options (Portfolio 383)

Tax Management Portfolio, 383-5th T.M., Nonstatutory Stock Options, examines the rules governing the taxation of stock options granted to employees by their employers as compensation for services rendered. Under the Internal Revenue Code, there are two basic types of compensatory stock options — statutory and nonstatutory.

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DESCRIPTION

Tax Management Portfolio, 383-5th T.M., Nonstatutory Stock Options, examines the rules governing the taxation of stock options granted to employees by their employers as compensation for services rendered. Under the Internal Revenue Code, there are two basic types of compensatory stock options — statutory and nonstatutory. This Portfolio focuses on nonstatutory stock options. For an analysis of the rules governing the taxation of statutory stock options, see 381 T.M., Statutory Stock Options. Section 83 of the Code (and §409A, as applicable) governs the taxation of compensatory nonstatutory stock options as part of that section's coverage of the taxation of all property transferred in connection with the performance of services. For a detailed discussion of §83, see 384 T.M., Restricted Property — Section 83.
The Worksheets include a sample nonstatutory stock option/stock appreciation rights plan and other practitioner aids. To assist in researching a particular topic, a Bibliography is provided.


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AUTHORS

MATTHEW J. EICKMAN, ESQ.
Matthew J. Eickman, Esq., B.S.B.A., University of Nebraska-Lincoln (finance and economics, With Highest Distinction 1999); J.D., Baylor Law School (magna cum laude, 2003); member, American Bar Association (Tax and Labor and Employment Sections).

TABLE OF CONTENTS

Detailed Analysis

I. Introduction

A. Overview

B. Definitions

1. Option

2. Option and Purchase Distinguished

3. “Stock” Option

C. Statutory Structure and Interrelationships

II. Income Taxation of Nonstatutory Stock Options

A. Taxation of Employee

1. Section 83 and Tax Stakes in NSO

2. Readily Ascertainable Fair Market Value

a. Actively Traded Options

b. Options Not Actively Traded

c. Option Privilege

d. Theory of Statute and Regulations

e. Congressional Criticism of Regulations

f. Legal Foundation for Statute and Regulations

(1) Structure of Taxation

(2) Transferability Restrictions

(3) Restrictions Significantly Affecting Value of Option or Underlying Property

(4) Time of Exercise Restrictions; McNamara and Stone

(5) Option Privilege

(6) Conclusions

g. Election Valuation of Untraded Options

h. Planning Considerations

3. Options with Readily Ascertainable Fair Market Value at Grant

a. Rules of 83

b. Taxation of Option at Grant

c. Basis, Holding Period of Option Taxed at Grant

d. Disposition, Cancellation of Option Taxed at Grant

e. Exercise of Option Taxed at Grant

f. Basis, Holding Period in Underlying Property

g. Disposition of Underlying Property

h. Lapse of Compensatory Option Taxed at Grant

4. Options Without Readily Ascertainable Fair Market Value at Grant

a. Exercise of Option Not Taxed at Grant

b. Disposition, Cancellation of Option Not Taxed at Grant

c. Basis, Holding Period in Underlying Property

d. Disposition of Underlying Property

e. Lapse of Option Not Taxed at Grant

5. Effect of Restrictions Attached to Options or to Underlying Property

a. Taxation of Options at Grant

(1) Options Actively Traded

(2) Options Not Actively Traded

b. Taxation of Underlying Property at Exercise

(1) Substantial Risk of Forfeiture

(2) Nontransferability

(3) Section 16(b) Restrictions

(4) Nonlapse Restrictions

c. Section 83(b) Election

(1) General Rules

(2) Planning Considerations

(3) Limitations on Election

d. Income Generated by Property During Restricted Period

e. Disposition of Restricted Stock

f. Forfeiture of Restricted Stock

(1) Before Substantial Vesting

(2) After Substantial Vesting

6. Effect of Death of Employee

a. Option Taxed at Grant

b. Option Not Taxed at Grant

c. Transfer of Restricted Property at Death

7. Effect of Divorce of Employee

B. Taxation of Employer

1. Employer's Deduction - General Rule

a. Allowability

b. Amount

c. Timing

2. Exception for Substantially Vested Property

3. Limitations on Employer Deduction

a. Withholding Requirement

b. Capitalization Limitation

c. $1 Million Deduction Limit on Covered Employees

4. Employer Gain or Loss

a. General Rules

b. Option Transactions

5. Effect of Restrictions Attached to Option or Underlying Property

a. Forfeiture of Property Before Taxation to Employee

b. Forfeiture of Property After Taxation to Employee

6. Employment Taxes

a. General Rules

b. Mechanics of Withholding

7. Property Transfers by Shareholders

III. Option-Related Transactions

Introductory Material

A. Stock Appreciation Rights

1. Definition

2. Taxation of Stock Appreciation Rights

a. To Employee

(1) Taxation at Exercise

(2) Taxation at Grant

(3) Constructive Receipt Issues

b. To Employer

(1) Deduction for SARs - Cash Method

(2) Deduction for SARs - Accrual Method

(3) Recognition of Gain or Loss

c. Use of SARs with Nonstatutory Options

d. Employment Taxes

B. Options with Employer Stock, and Rev. Rul. 80-244

1. Analysis of Rev. Rul. 80-244

2. SARs and Rev. Rul. 80-244

3. Unanswered Questions About Rev. Rul. 80-244

a. Operation with Restricted Stock

b. Pyramiding

4. Considerations for Employer

C. Section 409A and the American Jobs Creation Act of 2004

1. In General

2. Deferral of Compensation

a. In General

b. Stock Appreciation Rights, Stock Options, Restricted Property

(1) Coverage by 409A

(2) Valuation

(3) Modifications

(4) Restricted Property

3. Substantial Risk of Forfeiture

4. Distributions

a. Distribution Events

b. Changes in Ownership and Control

(1) In General

(2) Change in the Ownership of a Corporation

(3) Change in the Effective Control of a Corporation

(4) Change in the Ownership of a Substantial Portion of a Corporation's Assets

c. Acceleration of Payments

5. Funding

6. Reporting and Withholding

a. Information Reporting for Deferred Amounts

b. Wage Withholding for Employees

c. Reporting Nonemployee Compensation

7. Effective Dates and Transition Rules

a. In General

b. Final Regulations on Statutory Effective Dates

(1) In General

(2) Calculation of Grandfathered Amount

(3) Material Modifications

(a) In General

(b) Adoptions of New Arrangements

(c) Suspension or Termination of a Plan

(d) Changes to Investment Measures for Account Balance Plans

(e) Rescission of Modifications

c. Substitutions of Nondiscounted Stock Options and SARs for Discounted Stock Options and SARs

d. Transition Relief and Guidance on Corrections of Certain 409A Operational Failures

IV. Stock Option Practices

Introductory Material

A. Phantom Stock Options

B. Restricted Stock Options

C. Performance Grants

D. Indexed Options

E. Debt-Financed Option Exercise


WORKING PAPERS

Working Papers

Table of Worksheets

Worksheet 1 Exercise of Nonstatutory Options Using Employer Stock Pyramiding - Illustrations

Worksheet 2 Nonstatutory Option/Stock Appreciation Rights Plan

Worksheet 3 Stock Option Agreement

Bibliography

OFFICIAL

Statutes:

Regulations:

Legislative:

Treasury Rulings:

Cases:

Treatises:

UNOFFICIAL

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