Page 189 - Essentials of Payroll: Management and Accounting

ESSENTIALS of Payr oll: Management and Accounting
Incentive stock options are not taxable to the employee at the time
they are granted, nor at the time when the employee eventually exer-
cises the option to buy stock. If the employee does not dispose of the
stock within two years of the date of the option grant or within one

year of the date when the option is exercised, then any resulting gain
will be taxed as a long-term capital gain. However, if the employee sells
the stock within one year of the exercise date, then any gain is taxed as
ordinary income. An ISO plan typically requires an employee to exer-
cise any vested stock options within 90 days of his or her voluntary or
involuntary termination of employment.
The reduced tax impact associated with waiting until two years

have passed from the date of option grant presents a risk to the employee
that the value of the related stock will decline in the interim, thereby
offsetting the reduced long-term capital gain tax rate achieved at the end
of this period. To mitigate the potential loss in stock value, the employee
can make a Section 83(b) election to recognize taxable income on the
purchase price of the stock within 30 days following the date when an
option is exercised, and withhold taxes at the ordinary income tax rate
at that time. The employee will not recognize any additional income
with respect to the purchased shares until they are sold or otherwise

transferred in a taxable transaction, and the additional gain recognized
at that time will be taxed at the long-term capital gains rate. It is rea-
sonable to make the Section 83(b) election if the amount of income
reported at the time of the election is small and the potential price
growth of the stock is significant. That said, it is not reasonable to take
the election if there is a combination of high reportable income at the
time of election (resulting in a large tax payment) and a minimal

chance of growth in the stock price, or that the company can forfeit
the options. The Section 83(b) election is not available to holders of
options under an NSO plan.

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