What Is It?
An incentive stock option is a right or option granted by University of Missouri to its employees to purchase company shares at a certain price for a specified period of time, notwithstanding an increase in the value of the stock after the option is granted. It is sometimes referred to as a qualified or statutory stock option.
Example(s): Assume that as a result of her outstanding sales performance during the year, Marissa was given a bonus: an option to purchase 1,000 shares of stock at $10 per share within the next 10 years. Within 15 months, the value of the stock had risen to $15 per share. If Marissa chose to exercise her option at that point, she would pay only $10,000 for stock that was actually worth $15,000.
How Do You Exercise an Incentive Stock Option?
Typically, an employee exercises the option by paying cash equal to the exercise price or by tendering shares of University of Missouri that he or she already owns. With respect to the stock method, the employee can engage in a nontaxable stock-for-stock exchange (under Internal Revenue Code Section 1036). Basis in the shares transferred becomes the basis in an equal number of the new shares.
What Are The Requirements of Internal Revenue Code Section 422?
Incentive stock options provide favorable tax treatment to the employee, but for an option to be considered an incentive stock option for tax purposes, it must satisfy certain requirements set forth in Internal Revenue Code Section 422. These requirements are as follows:
- The incentive stock option may be granted only to an employee of University of Missouri (or its parent or subsidiary). Employee status generally must be maintained from the grant of the option until its exercise, although an employee may exercise the option within three months following a termination of employment (within one year if disabled).
- The written stock plan must specify the total number of shares that may be purchased. It must also specify the employees or class of employees who are eligible to receive the stock options. Additionally, the plan must be approved by University of Missouri's stockholders within 12 months before or after the plan is adopted by the company's board of directors.
- The option cannot provide that it will not be treated as an incentive stock option.
- The option must be exercised within 10 years after it is granted.
- The option must be granted within 10 years after the earlier of (1) the date the plan was adopted or (2) the date the plan was approved by University of Missouri's stockholders.
- The incentive stock option (by its terms) can be transferred by the employee only at death (through a will or by the laws of descent and distribution). While the employee is alive, only he or she can exercise the option to purchase stock.
- The option exercise price must not be less than the fair market value (FMV) of the stock on the date of grant.
- If the option is granted to a 10-percent-or-more shareholder, the exercise price must be at least 110 percent of the fair market value (FMV) of the stock (rather than 100 percent). Furthermore, the option may not be exercisable after the expiration of 5 years (rather than 10 years from the date the option is granted).
- The maximum total value of the stock (determined as of the grant date) that is first exercisable during any one calendar year may not exceed $100,000 for any one employee. Thus, for example, an incentive stock option award could permit acquisition of up to $500,000 worth of stock if it provided that the options were exercisable in five installments, each of which becomes exercisable in a different year and does not exceed $100,000.
- If the employee sells the stock within two years of the date the option is granted, or within one year of the date the option is exercised, the sale is considered a 'disqualifying disposition.' Certain transfers of the stock during this time period may also result in a 'disqualifying disposition.' A disqualifying disposition results in the loss of favorable tax treatment. In other words, the employee must meet the holding period requirements. The University of Missouri stock acquired under the option must be held for at least two years from the time it is granted and one year from the time it is exercised.
Tip: It is important to note that an incentive stock option may contain additional terms and conditions that are not inconsistent with Internal Revenue Code Section 422. These terms may be more restrictive. For instance, the option exercise price may increase each year. In addition, an option can expire immediately upon termination of employment, rather than allowing an employee to exercise the option during the three-month period following termination.
When Can It Be Used?
- Corporation needs incentive to retain key employees
- Cash bonuses are not available or appropriate
- Executive (or employee) requires stock ownership as incentive
- Stock has long-term growth potential
- Current owners are willing to dilute their ownership
Note that incentive stock options can only be used by corporations; they are not available to the employees of a partnership or limited liability corporation (LLC).
Strengths
Tax Deferral
The optionee (employee) does not recognize income or capital gain until a disposition occurs (generally, that means until the stock is sold). Therefore, taxation is deferred. The amount recognized is the difference between the amount paid for the stock and the sale price.
Favorable Capital Gain Rate
Assuming the holding period requirements are met, taxes are measured (in the year the stock is sold) at capital gain rates, which are usually more favorable than ordinary income rates. If the shares are held for at least two years from the date the option was granted and at least one year from exercise, the tax on sale is payable at a long-term capital gain rate. If the holding period requirements are not met, the gain is taxed as a combination of ordinary income and capital gain.
No Withholding Obligation on University of Missouri
Assuming the holding period requirements are met, there is no withholding tax obligation on University of Missouri at the time of exercise of the option (because there is no income tax obligation) nor at the time of disposition of the stock. Therefore, compensating an employee with incentive stock options provides cash flow benefits to University of Missouri not present in other stock compensation arrangements.
Helps University of Missouri to Attract, Motivate, And Retain Key Employees
A principal challenge to employers is to attract, motivate, and retain key employees (and executives in particular). These goals can be promoted by giving employees an equity interest in the business. Incentive stock options accomplish this task.
Avoids Cumbersome Employee Retirement Income Security Act (ERISA) Requirements
Many employers offer qualified retirement plans to employees; generally, such plans are subject to cumbersome ERISA rules pertaining to funding, vesting, disclosure, and other areas. Nonqualified plans are generally not subject to most of ERISA. By selecting a nonqualified plan such as an incentive stock option, you can sidestep the cumbersome aspects of ERISA.
Therefore, from University of Missouri's standpoint, it is wise to structure stock plans in a way that reserves the greatest degree of discretion with respect to the selection of participants, the size of awards, and the ability to terminate and reduce plan benefits. For practical purposes, this means that employers often offer incentive stock options only to executives--not to rank-and-file employees.
Avoids IRC Section 409A Requirements
IRC Section 409A contains complex rules that govern nonqualified deferred compensation (NQDC) plan deferral elections, distributions, funding, and reporting. If a NQDC plan fails to satisfy Section 409A's requirements, participants may be subject to current income tax, as well as an interest charge and 20 percent penalty tax. The IRS has stated that Section 409A does not apply to incentive stock option plans.
Provides Incentive for the Employee By Providing an Ownership Interest In University of Missouri
Executives and other employees are much more likely to put forth their best efforts when they have an ownership interest in the business. If University of Missouri is successful, the value of its stock will rise (and so will the employee's investment).
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Minimizes the Use of Corporate Funds for Payment of Compensation
Cash flow is increased because the business does not need to pay out cash to provide employees with deferred compensation.
Tradeoffs
University of Missouri Does Not Get a Tax Deduction
University of Missouri is not entitled to any deduction from gross income with respect to the grant or exercise of the incentive stock option or the disposition by the employee of the stock if the relevant holding periods are met by the optionee. If the optionee makes a disqualifying disposition, however, University of Missouri is entitled to a deduction for a compensation expense equal to the amount of ordinary income recognized by the optionee.
University of Missouri Has Less Flexibility, Due to Internal Revenue Code Section 422
Code Section 422 is fairly restrictive and cumbersome. University of Missouri might enjoy greater flexibility by offering a nonqualified stock option, which is not subject to Section 422.
Employee May Be Subject to Alternative Minimum Tax (AMT)
The employee may be subject to AMT in the year of exercise of the stock option because the exercise gives rise to an adjustment of AMT income. More specifically, the excess of the stock's fair market value at the time of exercise over the option exercise price is a tax preference item that may trigger an AMT obligation.
How to Do It
Consult an Attorney Regarding Your State's Laws
Federal tax law regarding incentive stock options is uniform. It is possible that state law may differ, however, so it is important to consult an attorney to ensure that you understand your state's approach to incentive stock options as well.
Seek the Guidance of an Attorney And/or Certified Public Accountant to Set Up Your Incentive Stock Option Plan
Your plan must comply with the requirements of Internal Revenue Code Section 422. Therefore, it is essential that you consult an employee benefits/Employee Retirement Income Security Act (ERISA) attorney to set up your plan properly. It may be necessary to consult with a certified public accountant as well.
Tax Considerations
Income Tax
To The University of Missouri Employee
An employee will not recognize any taxable income on the grant of an incentive stock option. Tax is deferred until there is a disposition of the stock. (Disposition means any sale, exchange, gift, or transfer of legal title.) The price at which the option was exercised becomes the taxpayer's basis in the stock.
The tax treatment on the disposition of the stock depends on whether the stock was sold by the employee within the proper holding period. The holding period is the later of two years from the date of grant or one year from the date of exercise by the employee. A disposition of the stock prior to the expiration of the holding period will cause the recognition of 'compensation income,' which is ordinary income tax treatment on the difference between the fair market value (FMV) of the stock and the option price on the date of exercise. This compensation income recognized is added to the basis of the stock. Any later increase in the value of the stock from the date of exercise to the date of disposition will be treated as capital gain (short- or long-term).
Example(s): Jack was granted an incentive stock option in Year 1 to acquire 1,000 shares of ABC stock at $10 per share. Six months later, he exercised his option when the FMV of the stock was $15 per share. Eleven months after buying the stock, Jack sold his 1,000 shares at $20 per share. Since he did not hold the stock for the required period of time, he has a disqualifying disposition on the date of the sale.
Example(s): In the year of the sale of his stock (the disqualifying disposition), Jack recognizes compensation income of $5 per share ($15-$10). He then adds the $5 per share income to the basis of his stock to arrive at a new basis of $15 per share. When he sells the stock at $20 per share, he has a short-term capital gain of $5 per share ($20-$15).
If the employee complies with the holding period requirements, by comparison, he or she will enjoy the more favorable long-term capital gain treatment when the stock is sold. To receive this tax treatment, the employee must not dispose of the acquired University of Missouri stock for: at least two years from the date the option was granted; and, at least one year after the employee exercised the option.
Caution: The employee may be subject to alternative minimum tax in the year of exercise of the stock option.
To University of Missouri
University of Missouri is not entitled to any deduction from gross income with respect to the grant or exercise of the incentive stock option or the disposition by the employee of the stock if the relevant holding periods are met by the employee. If the employee makes a disqualifying disposition, however, University of Missouri is entitled to a deduction for a compensation expense equal to the amount of ordinary income recognized by the employee. There is no withholding tax obligation to University of Missouri at the time of exercise of the option or at the time of disposition of the stock.
Gift and Estate Tax
Gifts of Incentive Stock Options
A gift entails a transfer of the donor's basis in the stock to the donee. A gift of incentive stock option stock should not be made until the statutory holding period has been met. Otherwise, the donor will recognize compensation income equal to the difference between the FMV of the stock and the option price on the date of exercise. Gifts of incentive stock options may be subject to gift tax.
Death of The Incentive Stock Option Holder
Incentive stock options are includable in the option holder's gross estate for estate tax purposes. In general, the assets of a decedent are afforded a step-up in basis at death, and this rule applies to incentive stock options. A step-up in basis means that the fair market value of the University of Missouri stock on the date of the employee's death becomes the new basis for the stock. The basis of unexercised stock options is stepped-up to FMV at death as well.
Example(s): If John had an option to purchase $10,000 shares of stock at $10 per share and the value of the stock had risen to $15 per share at his date of death, John's executor or administrator would use $15 per share (the FMV at date of death) for the stock basis.
Caution: If the estate of a person who died in 2010 elects out of the estate tax, assets transferred at death will not receive a step-up in basis but will receive a carryover or modified carryover basis instead.
How does the eligibility criteria for the Defined Benefit Retirement Plan at the University of Missouri System differ for Level One and Level Two members, particularly in regard to their hire or rehire dates?
Eligibility Criteria for Level One and Level Two Members: Level One members are employees hired before October 1, 2012, or those rehired before October 1, 2019, who had earned a vested benefit but did not receive a lump sum. Level Two members are those hired or rehired between October 1, 2012, and October 1, 2019, without eligibility for Level One benefits. Employees hired after October 1, 2019, do not accrue service credit under the DB Plan(University of Missouri …).
In what ways do service credits accumulated at the University of Missouri System impact an employee's retirement benefits, and how can employees ensure that they effectively maximize their service credit over the years?
Impact of Service Credits on Retirement Benefits: Service credits are critical in calculating retirement benefits at the University of Missouri System. Employees accumulate service credits based on their years of service, which directly affect their pension calculations. Maximizing service credits involves consistent full-time employment without breaks, as any leave of absence or part-time status may impact the total service credits earned(University of Missouri …)(University of Missouri …).
What are the various options available to employees at the University of Missouri System for receiving their retirement benefits upon reaching normal retirement age, and how do these options influence long-term financial planning for retirement?
Retirement Benefit Options: Upon reaching normal retirement age, employees can choose between a Single Life Annuity or a Joint and Survivor Annuity, both with options for lump-sum payments of 10%, 20%, or 30% of the actuarial present value. These choices influence monthly payout amounts, and selecting a lump sum reduces future monthly benefits proportionally(University of Missouri …).
With respect to the University of Missouri System's Defined Benefit Plan, how are employees' contributions structured, and what implications does this have for their overall retirement savings strategy?
Employee Contributions: Employees contribute 1% of their salary up to $50,000 and 2% for earnings beyond that threshold. This structure helps fund the DB Plan, with the University covering the majority of the cost. Employees need to factor in these contributions as part of their overall retirement savings strategy(University of Missouri …).
How can employees at the University of Missouri System assess their eligibility for early retirement benefits, and what considerations should be taken into account when planning for an early retirement?
Early Retirement Eligibility: Employees may retire early if they meet specific criteria: at least 10 years of service credit for ages 55–60 or at least 5 years of service credit for ages 60–65. Early retirees will receive a reduced benefit to account for the longer payout period(University of Missouri …).
What tax implications should employees of the University of Missouri System be aware of when it comes to distributions from their retirement plans, and how can they effectively navigate these implications?
Tax Implications of Retirement Plan Distributions: Distributions from the University of Missouri System’s DB Plan are subject to federal taxes. Employees can mitigate tax burdens by electing to roll over lump-sum distributions to a qualified retirement account, such as an IRA, to avoid immediate tax liability(University of Missouri …).
What are the policies regarding the continuation of benefits for employees who leave the University of Missouri System, particularly for those who are not vested or are classified as non-vested members?
Non-Vested Employee Policies: Employees who leave the University before vesting in the DB Plan (fewer than 5 years of service) are not eligible for retirement benefits but can receive a refund of their contributions. These non-vested employees must decide whether to receive their refunded contributions as a lump sum or through a rollover to another retirement account(University of Missouri …).
How might changes in employment status, such as taking a leave of absence or returning to work after a break, affect the service credit calculation for an employee at the University of Missouri System?
Impact of Employment Status Changes on Service Credit: Employees who take leaves of absence or return after breaks in employment may experience reductions in service credit. However, certain types of leave, such as military service or medical leave, may allow employees to continue earning service credit(University of Missouri …)(University of Missouri …).
In the event of an employee's death prior to retirement, what benefits are available to their survivors under the University of Missouri System's Defined Benefit Plan, and how can members ensure their wishes are respected?
Survivor Benefits: In the event of an employee’s death before retirement, survivors may be eligible for either a lump sum or monthly payments. Employees can designate beneficiaries to ensure that their wishes are honored, providing financial protection for dependents(University of Missouri …).
How can an employee at the University of Missouri System contact the Human Resources Service Center to obtain personalized assistance regarding their retirement options and any inquiries related to their retirement plan details? These questions require detailed answers and are designed to facilitate a comprehensive understanding of retirement processes and options for employees of the University of Missouri System.
Contacting HR for Assistance: Employees can contact the Human Resources Service Center for personalized assistance regarding their retirement options by emailing hrservicecenter@umsystem.edu or visiting the myHR portal for further details(University of Missouri …).