The following article is adapted and reprinted from the M&A Tax Report, Vol. 9, No. 10, May 2001, Panel Publishers, New York, NY.


By Robert W. Wood, San Francisco

Most of us in the tax field understandably focus on the tax treatment (rather than accounting treatment) of any particular issues affecting M&A. An example would be stock options, whether nonqualified options or incentive stock options ("ISOs"). Whether one believes the tax benefits of ISOs are as great as they are cracked up to be, it is certainly indisputable that there are a number of qualification restrictions on ISOs that make them unattractive to many circumstances. ISOs, for example, are subject to many approval requirements, timing and duration requirements, exercise rules, percentage tests, and a whole host of other limitations (the major categories of which are listed below). For these and other reasons, nonqualified options constitute the bulk of the options floating around corporate America.

Accounting Important, Too

Although most tax lawyers are vaguely aware that there are earnings charge implications of stock options (and ISOs in particular), many have not thought seriously about these accounting rules in any detail. The following primer (a mix of tax plus accounting rules) ought to remedy that defect.

Accounting for Nonqualified Options

Nonqualified options ("NSOs") are best defined by exclusion. They encompass all options that do not meet the special requirements for ISOs. NSOs may be granted to both employees and nonemployees alike in exchange for their services (so independent contractors or consultants are okay). There are no restrictions on the options, making them infinitely flexible.

The tax rules are pretty straightforward. NSOs granted in connection with the performance of services are not taxable when granted unless they carry a readily-ascertainable fair market value. NSOs with a readily-ascertainable fair market value are generally only those traded on an established securities market.

When an NSO is exercised and stock is received, the holder is taxed on the difference between the price paid for the stock (the option exercise price) and the market value. This treatment applies whether or not the optionholder hangs onto the stock after the exercise or immediately sells it. See Reg. §1.83-7(a). See also Revenue Ruling 78-175, 1978-1 C.B. 304. The income from the exercise of the options is not only income, but constitutes compensation for services. See Reg. §1.83-7(a). Thus, employment taxes (and withholding rules) apply.

A good deal of NSO planning involves trying to avoid this ordinary income/compensation rule. An exception specifies that income will not be recognized on the date the NSO is exercised if the stock received is subject both to a substantial risk of forfeiture, and is nontransferable. In this event, the recipient of the stock will not be taxed until either of these two conditions lapse. I.R.C. §83(a).

Accelerating Income

An exception to this rule for NSOs applies where the employee elects to include the value of the option in income at the date of grant, even though it is subject to a substantial risk of forfeiture. The employee makes a Section 83(b) election, a one-page form that essentially says "I want to be taxed now." Predictably, these forms are typically filed only where the value of the option (valued without regard to the restrictions on the option) is quite low, or in some cases zero.

It has long been true that a traditional goal of an 83(b) election is aggressive: to take as little as possible into income as ordinary income. Then, voila, by virtue of the Section 83(b) election, the balance (that will eventually be realized when the option is exercised and the stock is later sold) will all be capital gain. Assuming the stock is held for the requisite holding period, it will be long-term capital gain.

Moreover, by virtue of the Section 83(b) election having been made, the timing of the taxation will differ. Some small amount of tax (or in some cases even zero) may be payable at the time the Section 83(b) election is made. If the election is made, the exercise of the options will not be a taxable event. Instead, the exercise will simply be a purchase (more like the ISO rules discussed below), but the spread between the option exercise price and the then value of the stock will not constitute income. All of this makes the Section 83(b) election a fairly nifty device.

Before we move on, just a couple of cautions about 83(b) elections. First, just because an NSO has a zero value doesn't mean that an 83(b) election is not required if you want to convert the potential gain into capital gain. The IRS has long successfully argued (and the Ninth Circuit, at least, has agreed) that an 83(b) election reporting zero value must be filed in order to convert a zero value option into a capital gain asset when the option is later exercised. See Alves v. Commissioner, 79 T.C. 864 (1982), affd. 734 F.2d 478 (9th Cir. 1984).

Another point about 83(b) elections deserves mention, simply because so many mistakes are made here — including by professionals. An 83(b) election must be made within 30 days of the grant of the restricted property (in this case, the options). The election must be filed within this 30 day period, and a copy of the election must accompany the taxpayer's return for the year in which the options were granted. I don't quite know what the IRS does with 83(b) elections (perhaps they go into a black hole somewhere), so some might argue that this 83(b) filing and timing mandate may not have any teeth. However, I would certainly want to have proof that I had timely filed the 83(b) election to avoid courting disaster.

Tax Deduction on NSOs

Let's look at the corporate tax deduction for a moment, before turning to accounting treatment. For tax purposes, when an NSO is issued, the company has not yet "paid" anything until the time it is taxable to the employee. There is a predictable reciprocity here. Assuming that the NSO is subject to restrictions (as most are), there is no income to the employee, and no deduction to the company, until the time that these restrictions lapse. Or, as in the case described above, if the NSO is exercised and the option has a spread between exercise price and fair market value, that amount of spread must be taken into income as wages by the employee/optionholder. Of course, this generates a corresponding deduction for the spread to the company.

Financial Statement Treatment of NSOs

The tax treatment of NSOs is pretty straightforward. Fortunately, that is also the case with their financial statement treatment. A company is not required to take a charge against earnings at the time that the NSOs are granted. It is only when they are exercised (and compensation is payable) that a charge to earnings is required. See FASB.

In the case of a Section 83(b) election, which by definition involves the employee/optionholder making an election to include in income something now, the same financial statement charge would apply to the company. Of course, it would only apply to the extent that the employee/optionholder took something into income. As noted above, the 83(b) election is often filed reporting zero or very little income, so this is not much of a concern to the financial statement of the company.

Tax and Accounting Primer for Nonqualified Stock Options, Vol. 9, No. 10, The M&A Tax Report (May 2001), p. 1.