Administering Stock Option Plans

This chapter discusses:

• Stock option plan creation.

• Stock option grants and validation of ISO limits.

• Exercise and release options.

Stock Option Plan Creation

This section 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 Option Types

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.

Stock Option Grants and ISO Limits

This section provides an overview of stock option grants and discusses the validation of ISO limits.

A stock option grant typically enables the optionee to purchase a specified number of shares of stock for a specified price over a specified period of time. Usually the right to purchase shares is detailed in the grant agreement and is contingent on the employee's continued service or other contribution to the organization for a specific period of time.

The most common types of stock options do not require a cash investment until the optionee purchases (exercises) the option shares.

Validation of ISO Limits

There is no limit to the number of option shares that can be granted as ISOs. However, only the first $100,000 in aggregate fair market value of shares (determined on the grant date) covered by a stock option, which is exercisable for the first time during any calendar year, qualifies as an ISO and receives preferential tax treatment. Any amounts first exercisable in excess of $100,000 are treated as NQs. If an individual quits and returns to the same organization within the same calendar year, the pre-termination ISO shares exercisable in that calendar year count against the limit even though they are no longer exercisable. The $100,000 limit is defined in the governing body rules and can be changed.

The following scenarios illustrate how Stock Administration interprets the $100,000 limit rule.

Maximum Rule Scenario

On March 6, 1995 12,500 shares are granted with an FMV of $50 and the following vesting schedule:

The NQ shares are calculated by multiplying the corresponding percentage over the limit by the number of shares that are first exercisable in each calendar year. In our example, 60 percent of 5000 shares is 3000 shares and 20 percent of 2,500 shares is 500 shares. The number of ISO shares granted is determined by subtracting the NQ shares from the shares first exercisable each year.

In the case of stock option repricing, the double counting only needs to occur in the year of the repricing. Shares exercisable in the years prior to and after the repricing do not need to be double-counted. The reprice rules are first exercisable in all years or first exercisable as of the reprice. Many organizations choose to count all periods with which shares are first exercisable from the repriced option, although this may limit the amount of shares that can be granted as ISOs in future years. You choose which method your organization uses.

Even Rule Scenario

On March 6, 1995 12,500 shares are granted with an FMV of $50 and the following vesting schedule:

In this example the NQ shares are calculated by multiplying the highest percentage over the limit by the number of shares first exercisable in each year. So, 60 percent of 5000 shares is 3000 shares and 60 percent of 2,500 shares is 1,500 shares. The number of ISO shares granted is determined by subtracting the NQ shares from the shares first exercisable each year.

Exercise and Release Options

This section discusses:

• Tax calculations for exercises and releases.

• Payment methods for stock option exercise and release.

When exercising stock options, optionees must decide how to pay for the shares, the related taxes and fees; and how they want the shares to be issued. Depending on the option type, optionees may incur ordinary income and have to pay taxes at the time of exercise.

Some stock options can be exercised before they are vested. The optionee pays for the shares at the time of exercise and the shares are typically held in escrow until the vesting date. At that time, the vested shares are released and become fully tradable by the optionee. While the shares are held in escrow, the organization typically has full repurchase rights to the unvested shares.

Tax Calculations for Exercises and Releases

For vested stock options exercises, depending upon the option type, ordinary income or alternative minimum tax (AMT) income is calculated at the time of the exercise. When an option is exercised prior to vesting the income calculation generally occurs when shares are released, free of restrictions. However, an optionee may choose to file an 83(b) election to accelerate the time at which the applicable ordinary income or Tax Preference Income for AMT is recognized.

When you calculate ordinary income Stock Administration enables you to calculate taxes by integrating with PeopleSoft Enterprise Payroll for North America, using Load Default taxes or by manually entering taxes into the system for the exercise. The tax page is not available when Tax Preference Income for AMT is calculated or when ordinary income is zero. Stock Administration does not support the calculation and collection of taxes based upon Tax Preference Income for AMT pursuant to the IRS guidelines under circular E. Consult your payroll administrator or tax advisor for further information.

Tax Preference Income for AMT is calculated at exercise or release (if a restricted exercise) for ISOs and ISO/SARs exercised for shares. Ordinary income is calculated at exercise or release (if a restricted exercise) for NQs, RSAs, NQ/SARs, and ISO/SARs exercised for cash (SAR exercise). ISOs exercised after the regulatory period for termination and disability are treated as NQs and therefore ordinary income is calculated.

Stock Administration supports these exercise and release methods: cash, loan, swap, same day sale, and sell to cover, along with trade for taxes. The different share and tax payment methods affect how the system calculates the ordinary income. If an exercise method involves a sale, such as same day sale or sell to cover the system must first look to the Stock Option Plan rules for sale income methods. The methods available for each option type are FMV; sales price; or lesser of FMV or sales price. The method chosen for the option type determines what price is used when calculating the ordinary income. If only some of the shares are sold the sale income method is used only to calculate the ordinary income for the shares sold. The remaining shares (exercised but not sold) use the FMV to calculate the remaining ordinary income.

Note. Stock Administration supports only IRS tax regulations, consequently the tax calculations and discussions are based on the IRS tax code.

The following tables compare different income calculations for the various exercise and release methods.

Calculating Tax Preference Income for AMT at Exercise

Calculating Ordinary Income at Exercise

Calculating Tax Preference Income for AMT at Release

AMT is calculated at Release if unvested shares are exercised and an Election 83(b) was not filed.

Calculating Ordinary Income at Release

When ordinary income is recognized at exercise or release you calculate and collect the withholding taxes for US employees. You need to define the stock tax types, percentages, and limits to enable the Load Default Tax process to calculate the appropriate withholding. When you set up the various Stock Tax Types you need to define the Country Code associated with the tax you are setting up. This enables you to set up the various taxes associated with different countries. When you click the Load Default Tax the system calculates taxes based on what is set up in the tables for the country and state code at the locality for the individual. If you use Payroll for North America you can use the Calculate Tax and Update Payroll functionality to calculate the withholding due at the exercise or the release. You need to set up stock tax types for integration with Payroll for North America in order to correlate tax class to tax type.

Payroll Integration Issues

If you use Payroll for North America you can take advantage of integrated processes to calculate taxes and send tax and ordinary income directly to payroll. Otherwise, you can generate the Options Income and Tax report to send to your payroll administrator.

Stock Option Exercise Methods and Release Methods

There are several methods optionees can use to pay for the cost of the shares and related taxes: cash, loan, stock swaps, same day sales, sell to cover, and SAR exercise.

Here's a brief discussion of each of these methods with examples illustrating how they work:

Cash

At the time of exercise, the employee is required to pay the total option price plus any withholding taxes due to the organization.

Example 1: Cash ISO Exercise

On August 22, 1998 an optionee was granted an ISO option to purchase 500 shares vesting in five annual increments beginning one year from the date of grant. The option price was $3.40 per share. On November 1, 1999 the optionee exercised the stock option for the first 100 shares. The FMV on the date of exercise was $12 per share. The calculation is:

No withholding taxes are calculated at exercise. Thus the optionee owes the company the cost of shares ($340.00) and receives 100 shares.

Example 2: Cash NQ Exercise

On September 22, 1998 an optionee was granted an NQ option to purchase 500 shares vesting in five annual increments, beginning one year from the date of grant. The option price was $3.40 per share. On November 1, 1999 the optionee exercised the stock option for the first 100 option shares. The FMV on the date of exercise was $12 per share. The optionee is a California resident for income tax purposes. The calculation is:

Taxes are based on your setup and whether you are integrated with Payroll for North America. For example, taxes might be calculated as follows:

Thus the optionee owes the company the sum of the cost of shares ($340.00) and the total taxes due ($362.49). The optionee pays the company $702.49 and receives 100 shares.

Loan

Loans are another form of a cash exercise. They typically require a loan agreement and a promissory note. You can select Loan as a payment method at the time of exercise, but all other aspects of loan administration are handled outside of the Stock Administration system.

All aspects of processing the exercise with the payment method of Loan are the same as those involving the payment method of Cash.

Stock Swaps

When optionees elect to exercise stock options by means of a stock swap, they are exchanging shares they already own for option shares. The shares exchanged are usually valued at the fair market value of the company's stock on the date of exercise.

In the case of a stock swap, the ordinary income or Tax Preference Income for AMT is calculated in the same manner as a cash exercise. If an optionee exercises a non-qualified stock option, ordinary income is recognized on the option shares acquired and taxes may be withheld. The shares required for the swap/trade are cancelled and sent back to either the stock plan or the treasury, according to the stock option plan rules.

The formula for calculating stock swaps is:

Cost of Share = Shares Exercised x Grant Price

Shares Required for Swap = Cost of Shares/Swap FMV

Example 1: ISO Stock Swap

An optionee was granted an ISO to purchase 500 shares vesting in five annual increments beginning one year from the date of grant. The option price was $3.40 per share. On November 1, 1999 the optionee exercised the stock option for the first 100 option shares via a stock swap. The FMV for both the exercise and swap was $12 per share. The swap rounding rule specifies to round down. The calculation is:

This assumes constructive delivery of swapped shares. The optionee owes the company $4.00 and receives 72 shares. The number of shares cancelled is 28. The cost basis for the shares issued becomes the amount due to the company divided by the net shares issued. In the above example the Cost Basis per share would be $.055555.

Example 2: NQ Stock Swap

If an optionee exercises a non-qualified stock option, ordinary income is recognized on the option shares acquired and taxes may be withheld. The shares required for the swap/trade are cancelled and sent back to either the stock plan or the treasury, according to the stock option plan rules.

On September 22, 1998 an optionee was granted an NQ option to purchase 500 shares vesting in five annual increments beginning one year from the date of grant. The option price was $3.40 per share. On November 1, 1999 the optionee exercised the stock option for the first 100 option shares using a stock swap and trade for taxes. The FMV for both the exercise and swap was $12 per share. The swap rounding rule is set to round down. The optionee is resides in California and has not met the limits for Social Security or SDI. The calculation is:

Taxes are calculated as follows:

The trade transaction is:

Recap of Exercise Transaction:

This assumes constructive delivery of swapped shares.

For a tandem SAR, only the exercise of shares could use a stock swap. If the optionee exercises the SAR shares using a stock swap, the transaction would be handled in exactly the same manner as for the corresponding ISO or NQ example.

An option that allows unvested shares to be exercised before they are vested, such as an RSA, does not allow the use of a swap at the time of exercise. A trade is only allowed at the time the shares are released when payment is needed to cover tax liability that might be due.

Same-Day Sale

A same day sale is when the optionee finances the exercise of a stock option by immediately selling 100 percent of the shares exercised or released.

Example 1: ISO Same Day Sale

On September 22, 1998 an optionee was granted an ISO to purchase 500 shares vesting in five annual increments beginning one year from the date of grant. The option price was $3.40 per share. On November 1, 1999 the optionee exercised the stock option for the first 100 option shares and sold all 100 shares at $12.50 per share. The FMV on the date of exercise was $12 per share. The sale income method for the stock plan is the lesser of the FMV or the sale price. The calculation is:

Thus the total due the Company = $340.00

The company instructs the transfer agent to issue 100 shares and deliver them to the stockbroker. The company also bills the stockbroker for the cost of shares ($340.00). The optionee then receives the difference between the Total Sale Price less the Total Due Company and any brokerage fees.

Example 2: NQ Same Day Sale

On September 22, 1998 an optionee was granted an NQ to purchase 500 shares vesting in five annual increments beginning one year from the date of grant. The option price was $3.40 per share. On November 1, 1999 the optionee exercised the stock option for the first 100 option shares. The FMV on the date of exercise was $12 per share. The optionee resides in the state of California for income tax purposes. The calculation is:

Taxes are calculated as follows:

The total due to the organization is = $340.00 + $362.49 = $702.49

The organization instructs the transfer agent to issue 100 shares for delivery to the stockbroker and bills the stockbroker for the cost of shares and taxes ($702.49). The optionee receives the total sales price less the total due the organization and any brokerage fees.

Sell to Cover

Sometimes the optionee only wants to sell a portion of the option shares to cover the exercise cost. Many times the optionee contacts the company to have them estimate using the current FMV, the total shares that would have to be sold to cover the cost of the exercise and applicable taxes. The following examples show how these types of transactions would be handled. Example 1: NQ Sell to Cover

On September 22, 1998 an optionee was granted an NQ to purchase 500 shares vesting in five annual increments, beginning one year from the date of grant. The option price was $3.40 per share. On November 1, 1999 the optionee sells enough stock (60 shares at a sale price of $12.50) to cover the exercise of 100 shares. The optionee wants to have the remaining 40 shares issued and delivered to himself. The FMV on the date of exercise was $12 per share. The sale income method for the stock plan is set to sale price. The optionee is a California resident for income tax purposes. The calculation is:

Taxes are calculated as follows:

The total due the company is $340.00 + $375.14 = $715.14

The company instructs the transfer agent to issue 60 shares and deliver them to the stockbroker, and issue 40 shares and deliver them to the optionee. The organization also bills the stockbroker for the option price and taxes ($702.49). The optionee receives the Total Sales Price less the Total Due Company and brokerage fees.

SAR Exercise

This method is only allowed if the option type is a tandem SAR (ISO/SAR or NQ/SAR). The underlying shares of the option are valued using the SAR FMV and the optionee is paid out the cash rights on these shares by subtracting the grant price from the SAR FMV determined on the date of the exercise. Taxes are typically due on the income at the time of the exercise for both ISO/SAR and NQ/SAR option types. Only when the individual exercises the right to the ISO shares can the preferential tax treatment be taken. The underlying shares that are used to value the cash rights are then cancelled and sent back to either the stock plan or the treasury, according to the Stock Option Plan rules specified. On September 22, 1998, an optionee was granted an ISO/SAR to purchase 500 shares that vests in five annual increments, beginning one year from the date of grant. The option price was $3.40 per share. On November 1, 1999, the optionee chose to exercise the cash right of the tandem SAR for the first 100 option shares. The SAR FMV on the date of exercise was $12 per share. The calculation is:

Withholding taxes are due on all SAR exercises. The funds paid to the optionee are treated as compensation and taxed accordingly for both ISO/SAR and NQ/SAR.

Taxes are calculated as follows:

Recap of SAR Exercise Transaction: