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Session 15 ISOs and NSOs

CERTIFIED FINANCIAL PLANNER CERTIFICATION PROFESSIONAL EDUCATION PROGRAM Retirement Planning & Employee Benefits. Session 15 ISOs and NSOs. Session Details. Nonqualified vs. Qualified Plans. “Stock” Plans. Restricted stock ISOs ESPPs NSOs SARs Phantom stock

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Session 15 ISOs and NSOs

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  1. CERTIFIED FINANCIAL PLANNER CERTIFICATION PROFESSIONAL EDUCATION PROGRAMRetirement Planning & Employee Benefits Session 15ISOs and NSOs

  2. Session Details

  3. Nonqualified vs. Qualified Plans

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

  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 grant1 • 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.

  6. Tax Treatment of Incentive Stock Options • No income tax is owed when the ISOs: • are granted and • 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”

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

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

  9. Taxation of ISO Disqualifying Disposition $25 $15 $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. Price Disposition price FMV at exercise $10 Held less than 1 year – entire gain taxed as ordinary income Exercise price $5 Holding period requirement not met Grant date Exercise date Disposition date Time

  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

  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

  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

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

  14. Stock Option Comparison (1)

  15. Stock Option Comparison (2)

  16. Stock Option Comparison (3)

  17. Multiple Choice 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? • Upon exercise, Rex will owe taxes (W-2 income) on $24,000(2,000 shares x $12 exercise price). • 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). • Upon exercise, Rex will be subject to AMT taxes of $45 per share. • Upon exercise, Rex will not owe any regular income taxes.

  18. Multiple Choice 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? • Upon exercise, Rex will owe taxes (W-2 income and payroll taxes) on $200,000 (4,000 shares x $50 per share). • 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). • Upon exercise, Rex will be subject to AMT taxes on $140,000. • Upon exercise, Rex will not owe any regular income taxes.

  19. Multiple Choice Data Jim Dandy, the CEO of Dandy Industries, was awarded the following stock options from his company: During the current year, 2014, Jim has the following transactions with the stock options: During the current year, Jim has the following transactions with the stock options:

  20. Multiple Choice Question 3 Which one of the following is correct regarding options AA for 2014? • Jim has W-2 income, subject to payroll taxes, of $186,000. • Jim has a short-term capital gain of $186,000. • Jim has a long-term capital gain of $186,000. • Jim has no tax liability since the shares were exercised but not sold.

  21. Multiple Choice Question 4 Which one of the following is correct regarding options BB for 2014? • Jim has a short-term capital gain of $58,000. • Jim has a long-term capital gain of $58,000. • Jim’s sale is a disqualifying disposition, and he has W-2 income of $58,000. • Jim has AMT income in the amount of $58,000.

  22. Multiple Choice Question 5 Which one of the following is correct regarding options CC for 2014? • Jim has no tax liability since the shares were exercised but not sold. • Jim has a $50,000 long-term capital gain since the shares have been held more than two years since the grant date. • Jim’s exercise is a disqualifying disposition, and he has W-2 income of $50,000. • Jim’s exercise will result in AMT income of $50,000.

  23. Multiple Choice Question 6 Which one of the following is correct regarding options DD for 2014? • Upon exercise, Jim will have W-2 income of $94,000. • Upon exercise, Jim will have W-2 income, with payroll taxes of $94,000. • Upon exercise, Jim will not owe any taxes since the shares have not been sold yet. • Upon exercise, Jim will have AMT income of $94,000, but no regular income taxation.

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

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

  26. CERTIFIED FINANCIAL PLANNER CERTIFICATION PROFESSIONAL EDUCATION PROGRAMRetirement Planning & Employee Benefits Session 15End of Slides

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