1. ©2015, College for Financial Planning, all rights reserved. Session 15 ISOs and NSOs CERTIFIED FINANCIAL PLANNER CERTIFICATION PROFESSIONAL EDUCATION PROGRAM Retirement Planning & Employee Benefits

2. Session Details Module8 Chapter4 LOs8-5 Identify characteristics of incentive stock options (ISOs) and employee stock purchase plans (ESPPs). 8-6 Identify characteristics of nonqualified stock options (NSOs) and other types of incentive stock plans. 15-2

3. Nonqualified vs. Qualified Plans CharacteristicQualified PlanNonqualified Plan Internal Revenue Code Requirements DiscriminationPlan may not discriminatePlan may discriminate ERISA RequirementsAll plans must satisfy ERISA and IRC requirements Certain plans are partially exempt from ERISA Tax Treatment Employer deductionAvailable in year of plan contribution Available in year of employee taxation Employee deferralTax-deferred until plan distribution; rollovers allowed Tax-deferred only if unfunded or funds are at risk; no rollovers Fund earningsEarnings accrue tax-deferred until distribution Earnings usually are currently taxable to employer DistributionsTaxed at ordinary rates; averaging may be available on lump sums Taxed at ordinary rates; averaging not available on lump sums 15-3

4. “Stock” Plans Restricted stock ISOs ESPPs NSOs SARs Phantom stock Performance unit or share plans Junior stock 15-4

5. Incentive Stock Options (ISO) Requirements Can only be offered to employees Must be issued under a written plan approved by the stockholders of the corporation The option term and exercise period cannot exceed 10 years The option price must equal or exceed the FMV of the stock at the time of the grant 1 The options must expire no later than three months after employment is terminated The option can only be exercised by the option holder and cannot be transferred, except at the death of the option holder No more than $100,000 can be exercised in one year 1 If the employee owns more than 10% of the voting stock of the company, the option price must be at least 110% of the FMV. 15-5

6. Tax Treatment of Incentive Stock Options No income tax is owed when the ISOs: o are granted and o are exercised The difference between grant and exercise price is AMT income in year of exercise (if stock is disposed of in same year as exercise, no AMT income) Income tax is owed when the stock purchased with the ISOs is sold How the gain will be taxed depends on whether the disposition is a “qualifying disposition” or a “disqualifying disposition” 15-6

7. $10 $15 $25 Price Understanding Stock Option Terms Time Disposition dateGrant dateExercise date Exercise price FMV at exercise Disposition price 15-7

8. Price Holding Periods and Taxation of ISOs Time Disposition dateGrant dateExercise date $10 $15 $25 Exercise price FMV at exercise Disposition price 2 years from grant 1 year from exercise 15-8

9. Price Taxation of ISO Disqualifying Disposition Time Disposition dateGrant dateExercise date $10 $15 $25 Exercise price FMV at exercise Disposition price Holding period requirement not met Held less than 1 year – entire gain taxed as ordinary income $5 $10 The tax treatment of a disqualifying disposition is the same as for an NQSO (except for FICA and withholding rules). Disqualifying dispositions generally do not have AMT ramifications. 15-9

10. Employee Stock Purchase Plans (ESPPs) $25,000 annual maximum Shares can be sold at up to a 15% discount Same holding period requirement as ISOs for capital gains treatment 15-10

11. Nonqualified Stock Options (NQSOs) Options can be given to both employees and non-employees Exercise price must equal or exceed FMV of stock at time of grant The company can set the requirements for exercising the options The company can determine the conditions under which the options are forfeited No holding period rules apply 15-11

12. Tax Treatment of NQSOs The options are not taxed when granted unless they have an ascertainable value Taxed as compensation (W-2 income) upon exercise of the option (bargain element) The employer receives a deduction for the amount taxed to the option holder Any change in value between the FMV at exercise and the disposition price is taxed as a long- or short-term capital gain or loss 15-12

13. Price Taxation of Nonqualified Stock Options Time Disposition dateGrant dateExercise date Exercise price FMV at exercise Disposition price Compensation Capital gains $5 $10 $25 $10 $15 15-13

14. Stock Option Comparison (1) The plan must:ISONQSO Be a written documentYes Declare the number of shares subject to grantYesNo Declare employees or classes eligibleYesNo Obtain shareholder approval 12 months before or after adoptionYesNo 15-14

15. Stock Option Comparison (2) The options must:ISONQSO Be granted within 10 years of approval or adoption of planYesNo Be exercisable no later than 10 years after the grant (5 years for >10% owner)YesNo Be exercisable at no less than FMV on date of grant (110% for >10% owner)YesNo Be nontransferableYesNo Be limited to no more than $100,000 a year in FMV of shares per yearYesNo 15-15

16. Stock Option Comparison (3) Recipient must meet holding period of:ISONQSO From date of grant2 yearsNone From date of exercise1 yearNone Be an employee on date of grantYesNo Exercise options within timeframe 3 months following termination No 15-16

17. Question 1 Rex works for Titan Industries, which is currently trading at $12 per share. The company awards him incentive stock options (ISOs) for 2,000 shares with an exercise price of $12. Rex exercises (but does not sell) the options three years later when the stock is trading at $45 per share. Which one of the following statements is correct? a.Upon exercise, Rex will owe taxes (W-2 income) on $24,000 (2,000 shares x $12 exercise price). b.Upon exercise, Rex will owe taxes (W-2 income) on $66,000 ($33 difference on 2,000 shares—difference between the $45 current price and $12 grant price). c.Upon exercise, Rex will be subject to AMT taxes of $45 per share. d.Upon exercise, Rex will not owe any regular income taxes. 15-17

18. Question 2 Rex was also granted some nonqualified stock options (NSOs), with an exercise price of $15 per share (issued when the company stock was trading at $15 per share). His grant was for 4,000 shares, which he exercises (but does not sell) two years later when the stock is trading at $50 per share. Which of the following statements is correct? a.Upon exercise, Rex will owe taxes (W-2 income and payroll taxes) on $200,000 (4,000 shares x $50 per share). b.Upon exercise, Rex will owe taxes (W-2 income and payroll taxes) on $140,000 ($35 difference on 4,000 shares – difference between the $50 current price and the $15 grant price). c.Upon exercise, Rex will be subject to AMT taxes on $140,000. d.Upon exercise, Rex will not owe any regular income taxes. 15-18

19. Multiple Choice Data Jim Dandy, the CEO of Dandy Industries, was awarded the following stock options from his company: During the current year, 2015, Jim has the following transactions with the stock options: During the current year, Jim has the following transactions with the stock options: Stock OptionGrant DateTypeGrant Price# of shares AAMar 1, 2007NSO$155,000 BBFeb 1, 2008ISO$201,000 CCOct 1, 2009ISO$301,000 DDAug 1, 2010NSO$355,000 Stock OptionDateAction Number of Shares Mkt Price on Action Date AAJan 1, 2015Exercise3,000$77 BBFeb 1, 2015Exercise1,000$78 BBFeb 1, 2015Sold1,000$78 CCMar 1, 2015Exercise1,000$80 DDApr 1, 2015Exercise2,000$82 DDOct 1, 2016Sold2,000$85 15-19

20. Question 3 Which one of the following is correct regarding options AA for 2015? a.Jim has W-2 income, subject to payroll taxes, of $186,000. b.Jim has a short-term capital gain of $186,000. c.Jim has a long-term capital gain of $186,000. d.Jim has no tax liability since the shares were exercised but not sold. 15-20

21. Question 4 Which one of the following is correct regarding options BB for 2015? a.Jim has a short-term capital gain of $58,000. b.Jim has a long-term capital gain of $58,000. c.Jim’s sale is a disqualifying disposition, and he has W-2 income of $58,000. d.Jim has AMT income in the amount of $58,000. 15-21

22. Question 5 Which one of the following is correct regarding options CC for 2015? a.Jim has no tax liability since the shares were exercised but not sold. b.Jim has a $50,000 long-term capital gain since the shares have been held more than two years since the grant date. c.Jim’s exercise is a disqualifying disposition, and he has W-2 income of $50,000. d.Jim’s exercise will result in AMT income of $50,000. 15-22

23. Question 6 Which one of the following is correct regarding options DD for 2015? a.Upon exercise, Jim will have W-2 income of $94,000. b.Upon exercise, Jim will have W-2 income, with payroll taxes of $94,000. c.Upon exercise, Jim will not owe any taxes since the shares have not been sold yet. d.Upon exercise, Jim will have AMT income of $94,000, but no regular income taxation. 15-23

24. Question 7 Which one of the following is correct regarding options DD? a.Upon sale of the stock, Jim will have W-2 income, with payroll taxes, of $100,000. b.Upon sale of the stock, Jim will have W-2 income of $6,000. c.Upon sale of the stock, Jim will have a long- term capital gain of $6,000. d.Upon sale of the stock, Jim will have AMT income of $100,000. 15-24

25. Question 8 Which of the following statements are true? I.Upon exercise, W-2 income is reported, and payroll taxes due, for NSOs. II.Upon exercise, W-2 income is reported for ISOs. III.Upon exercise, AMT taxable income will be created if the ISO is not sold by the end of the year. IV.If an ISO is sold in the same year as exercised, there will not be any AMT income reported. a.I and III only b.II and III only c.I, III, and IV only d.II, III, and IV only 15-25

26. ©2015, College for Financial Planning, all rights reserved. Session 15 End of Slides CERTIFIED FINANCIAL PLANNER CERTIFICATION PROFESSIONAL EDUCATION PROGRAM Retirement Planning & Employee Benefits