Definition
The term employee stock option plan refers to a compensation program that provides a select group of employees with the right to purchase a fixed number of shares of common stock at an attractive price and within a prescribed timeframe. Employee stock option plans can include both non-qualified stock options (NQSO) as well as incentive options.
Explanation
Unlike stock purchase plans, which are considered non-compensatory and provide employees with the ability to purchase shares of the company's common stock at a discount; stock option plans are typically provided to a select group of employees the company desires to retain.
These plans provide employees with the right to acquire a prescribed number of shares of the company's common stock, at a given price, and within a certain timeframe. Generally, these plans fall into one of the following two categories:
Non-Qualified Stock Options: as the name implies, these plans do not meet the stringent tax law requirements of qualified plans. Non-qualified stock options provide employers with a tax advantage relative to qualified plans. With an NQSO, the difference between the market value of the company's common stock and the option price is considered compensation of the employee, and the employer is allowed to expense this benefit once the right is exercised.
Incentive Stock Options: if the plan meets the requirements of the tax law, it can be treated as an incentive stock option plan, or ISO plan. With these plans, the employee does not owe income taxes when the right to purchase shares is exercised. If the employee sells the stock more than two years from the grant date, and more than one year after purchase or transfer, the sale is said to be a qualifying disposition and capital gains would be owed on the difference between the purchase and sales price. Note that exercising the right to purchase shares needs to be treated as income when calculating any alternative minimum tax owed.
Example
The board of directors for Company A has granted 50,000 shares of common stock to the company's CEO. The current market price of Company A's stock is $80.00 per share, while the options price is $75.00 per share. The expected benefit period for this non-qualified stock option is one year.
The value of the option at the time of grant would be as follows:
Current Market Value of Common Stock ($80.00 x 50,000) | $4,000,000 |
Option Price on Date of Grant ($75.00 x 50,000) | $3,750,000 |
Compensation Expense | $250,000 |
The journal entry to record the transaction would be as follows:
Debit | Credit | |
Deferred Compensation Expense | $250,000 | |
Paid-In Capital: Stock Options | $250,000 |
Related Terms
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