Spread Of Incentive Stock Options example essay topic

Since the late 1980's more and more people have been given the opportunity to purchase stock options. As of 2001, ten million employees have chosen to purchase stock options. Another survey established that 97 of the top 100 e-commerce companies gave the choice of options this year. For these reasons, it is important to understand what stock options are, the different types of options, and their advantages and disadvantages. A stock option gives any employee the right to buy a certain number of shares in the company at a fixed price for a certain number of years.

Employees who have been given the choice of stock options hope that the share price will go up and that they will be able to cash in by purchasing the stock at the lower grant price and then selling the stock at the current market price. Stock option plans can be a flexible way for companies to share ownership with employees, reward them for performance, and attract and retain a motivated staff. These plans could also encourage the employees to look in that best interest of the company and other shareholders. For growth-oriented smaller companies, options are a great way to preserve cash while giving employees a piece of future growth. They can also work for public firms whose benefit plans are well established, but who want to include employees in ownership. Options are not a mechanism for existing owners to sell shares and are usually inappropriate for companies whose future growth is uncertain.

They can also be unappealing in small, closely held companies that do not want to go public or be sold because they may find it difficult to create a market for the share. There have been disagreement on whether or not options are actual ownership. Some believe they are ownership because employees do not receive them for free, they use their own money to purchase the share. Others believe that since the employees can sell their shares a short time after purchasing them they do not have the long-term ownership goal. A few simple terms with stock options are a call, a put, and a premium.

A call is the right to buy the stock, a put is the right to sell the stock and its premium is the price of the option. Overall, options allow you to participate in price movements without committing the large amount of funds needed to buy stock outright. As mentioned earlier, incentive stock options and non qualified stock options are the two existing types of stock options. According two the article "Tax Attack", found in the November 2001 issue of Kiplinger's Personal Finance Magazine, an estimated ten million employees own stock options as of 2001. For this reason alone it is important distinguish between the two types of stock options.

The main difference between the two options is the way they are taxed. Non qualified stock options are most common. These options are taxed along with income. The difference between the price at which the employer is allowed to buy the stock and the value of the stock on the purchase day is called the spread. Hence, when non qualified stock options are bought their spread is taxed, just like income. This means that, just like a person's wage, social security and Medicare taxes will be taken out (Franklin and Stevenson, 2).

For example, a person has the option of buying stock at $4.00 from his employer. When the stock is trading for $6.00 the employee will buy 100 shares. The spread is $200.00 in this case. Therefore, to abide by the law, $200.00 will be recorded in the extra taxable income section of the W-2 form. Also, with this stock, if it is held for more than one year, the gains or losses will be taxed at the capital gains tax rate. If a loss is encountered, the capital gains rate allows for a tax savings loss.

Incentive stock options, conversely, are not taxed on income. The spread is not taxed at all. Instead, it is taxed at the capital gains tax rate. This means that social security and Medicare are not taken out of the gain. Also, this means that it is not taxed at the highest income tax bracket, which is extremely beneficial to the wealthy. For these reasons incentive stock options have been used as a way to obtain employees at lower wages (Franklin and Stevenson, 2).

There is a clear problem with incentive stock options that may seem hidden amidst all the benefits. The alternative minimum tax is the flaw with incentive stock options. The article "Tax Attack" states that this tax is". ... a parallel tax system created more than 30 years ago to ensure that everyone pays something to the IRS... it was never indexed to keep pace with inflation" (Franklin and Stevenson, 1). A person pays the alternative minimum tax instead of income taxes when the tax bill that results from the alternative minimum tax is higher than it would be under regular income taxes.

The alternative minimum tax differs from regular income taxes because it taxes the spread of incentive stock options and does not allow a person to deduct things such as state income taxes, property taxes, and exemptions for oneself and his dependents among other things. The one benefit is that the taxes paid on the spread can be used as a credit in future years to offset income taxes (Franklin and Stevenson, 2). In the article "Tax Attack", Angela Hartley, 48, owes $360,000 in taxes due to her purchasing of incentive stock options. This is because she is being taxed as though she had sold the stock for one million dollars. She actually still holds the stock today and its value is no where near this amount. This whole problem occurred because of the way the alternative minimum tax works.

To get into the specifications Hartley's tax debt and it relations to the incentive stock options would be very complex and out of the range of this paper. It is beneficial to note though, that when looking into purchasing stock options one should be confident in all the underlying tax rules and how they may effect future taxation. For many obvious reasons, stock options are appealing to employees. Most obvious is the opportunity for employees to gain large amounts of equity by buying the stock at the fixed market price and selling it in the market at its current higher price. Many employees are able to triple or even quadruple their normal earnings by exercising stock options then selling them.

As well as earning extra from selling the stock, employees are also earning more this way than if they just took their wages and walked because through use of their stock they are able to defer income taxes. The profit attained from the stock is conveniently not taxed until it is sold on the open market. Another benefit to the employee is simply being a stockholder. Now the employee is more than a worker bee in the company; he is a team player too. They are more included in the company because they now own part of it.

Seems like the employee is able to have his cake and eat it too. The only real downfall for the employee is exercising his stock at the wrong time and losing money. From the other end of the spectrum things are not quite as perfect. Stock options are an easy way for ownership to be weakened. When an employee exercises his stock options, the company has to either issue new shares or go out on the open market and purchase shares to compensate accordingly. If new shares are issued, then your ownership is diluted.

Another downfall from the company's standpoint is a net cash outflow. If the company purchases shares on the open market, then the company, which only receives the exercise price from the employee, has to pay market price for the shares it purchases. Along with the disadvantages, there are many more advantages for the company when it comes to stock options. They are a huge motivational tool for their employees, and long before the employees are even hired, stock options enable companies to recruit better employees. Once the employees are hired, they work harder for the sake of the company as well as a rise in their shares, and therefore, the company is able to retain hard working elites.

Another positive remark about stock options is that companies are not required by GAP to record them as an expense which, in turn, inflates their earnings. Just as before with the employee's stock income, the company receives a tax deduction as well. When the employee exercises his stock then sells it in the market he receives an income, and this amount received by the employee is equal to the tax break granted to the company. Hence, the larger the price difference, the better it is for both the employee and employer. To conclude, stock options are increasingly being used as incentives for employees in companies around the world.

Statistics state that the increased use of stock options privileges has increased the work ethic of employees, thus increasing sales. Stock options are a good non-cash compensation for increasing the moral of employees, but one should note that the underlying tax regulations could be complicated.