Stock Option Types

An option is a type of a contract between the buyer and seller that gives the buyer the right to purchase or sell the stock or the underlying asset under the option on before the expiration date of the said option but the buyer is not bound to buy or sell unlike a futures or forward contract. An employee stock option is an option granted by the company to an employee to buy if he chooses to, a certain amount of shares of the company. It is a type of a non-cash compensation offered to the employees. The company is legally obligated to grant the stocks if the employee chooses to exercise the employee stock options.

As far as the employee stock options are concerned there are two types of stock options: Incentive Stock Options (ISO) & Non-qualified Stock Options or Non Statutory Stock Options (NSO). ISOs which are granted to the employees carry a tax benefit for the employees and there are no restrictions attached to them. Whereas the NSOs carry no tax benefits for the employees but are less complicated than the ISOs.

The taxation on ISOs has an incentive for the employees because when the employee exercises his option he does not have to pay tax on the difference between the exercise price of the option and the market value of the shares underlying the option. The tax is payable by the employee only if the shares underlying the option are sold. The profit on such sale is taxed as long term capital gain tax and not as ordinary tax. This is beneficial as the rate of tax on long capital gain tax is less than the rate of tax on ordinary income. A restriction on the ISOs is that the maximum amount of ISOs that can be exercised each year by the employee is restricted to $100,000.

NSOs lack the tax benefits of the ISOs as when the option is exercised by the employee he is required to pay ordinary income tax on the difference between the exercising price of the option and market value of the shares underlying the option, thereby becoming an additional burden to the employee in terms of tax. Yet NSOs are more preferred by the employers as it enables them to have a deduction in their gross total income equivalent to the value the employee is required to consider as his income and pay tax thereon.

An employee can exercise a stock option in three of the following ways: cash, swapping of stocks and exercising without cash. The cash method is very simple; the employee pays the employer the required amount and gets the necessary stocks in return. In the stock swapping method if the employee is allowed to trade his company's stocks he can exchange his existing holdings for the stock options at the proportionate price but the employee should have his holdings for at least two years to avoid taxes on the swap of the shares. In the third method the of exercising the stock options without cash the employee can borrow money from a stock broker to exercise the option and can then sell sufficient amount of shares to repay his loan to the broker.

As far as the accounting of stock options is concerned by the employer the USA GAAP states that the stock options granted to the employees should be treated as expense in the company's income statement only when the employee exercise the stock options and not before that. For valuing the stock options the employer is allowed to follow either the lattice model or the Black Scholes Merton formula.