Understanding Stock Option Plan Creation

This topic discusses the creation of stock option plans and the various types of stock options the system supports.

Stock Administration enables you to create and manage a variety of stock option plans. You can grant options individually or through a variable compensation program according to your organization's business rules, and track exercise, release, repurchase, and disposition transactions.

The stock option plan process starts with your management designing a stock program, frequently assisted by outside consultants and legal counsel. The organization's board of directors or a compensation committee decides on the number of shares to place in the stock option pool. Following adoption by the board, a stock option plan is often submitted to the organization's shareholders for approval at their annual meeting. State corporate law may require such approval or it may be required by the organization's charter documents, or by the stock exchange on which the organization's stock is traded.

Usually it's not necessary to obtain Securities and Exchange Commission (SEC) approval before implementing an employee stock plan. However, for publicly traded stock, the plan must be registered with the SEC before offers or sales of securities under the plan may commence. You may have to register the stock plan with the appropriate state agency before the plan can be used, unless an exemption from qualification or registration is available.

A stock option plan typically allows an organization to set the terms and conditions of its program on a company-wide basis, thereby avoiding individual negotiations with employees. Besides the plan document, an organization may have written policies and procedures concerning its stock option activities. Depending upon the provisions within the stock option plan, your organization may need several different plans. For example, an Incentive Stock Option (ISO) plan only for employees, and a Non-Qualified Stock Option (NQ) plan for employees, consultants, and outside board members. A single plan can allow for the granting of various stock option types, such as ISO, NQ, and Restricted Stock Awards (RSAs). This type of plan is commonly called an omnibus plan.

Stock Administration supports the following types of stock options:

Non-Qualified (NQ) Stock Options

NQs allow optionees to purchase stock directly from the company. The grant price may be less than the fair market value on the date the option is granted. When the option is exercised, the optionee (if a US resident) is generally taxed at the ordinary income tax rate on the difference between the option price and the fair market value at exercise. The optionee's company is entitled to a corresponding tax deduction.

Incentive Stock (ISO) Options

ISOs give individuals the right to purchase stock without incurring federal tax consequences at the time of the exercise. To maintain the preferential tax treatment the current IRS rules state the following:

  • ISO options can only be granted to employees of the organization.

  • The grant price must not be less than fair market value on the date of the grant. If an employee owns more than 10 percent of the organization's outstanding stock the option price must be at lease 110 percent of the grant FMV.

  • The number of shares first exercisable in each calendar year may not exceed an aggregate value of $100,000.

  • The option term may not exceed 10 years from the date of the grant. However, if an employee owns more than 10 percent of the organization's outstanding stock the option term may not exceed five years.

Tandem Stock Appreciation Rights

A tandem stock appreciation right (NQ/SAR or ISO/SAR) is a contractual right granted with a stock option that allows the optionee to receive the cash value equal to the appreciation on the specified number of shares exercised, or the shares of stock. If a stock distribution is made, the exercise is treated like a stock option exercise for the option type granted. The appreciation value is based on the difference between the grant price and the fair market value at exercise. When the cash appreciation is paid out, estimated income taxes are usually due on the gain.

Restricted Stock Awards (RSAs)

RSAs are generally given to key employees but can be granted to any individual. RSAs are usually granted below the current fair market value and often the grant price is set to the par value of the common stock. Optionees can exercise shares before they vest. Shares are typically held in escrow until they vest and are released. When optionees terminate before the rights to the shares are vested, organizations typically exercise their right to repurchase the shares at the option price.

Because of the risk of forfeiture, ordinary income and taxes are not calculated until the shares vest. The ordinary income equals the difference between the grant price and the fair market value on the vesting date. The optionee may elect to incur ordinary income at the time of issuance (exercise) by filing an 83(b) election.