332 Planning and Forecasting
to pay a bonus based upon a certain formula. Since these devices are not rec-
ognized as capital assets, they are not eligible to be taxed as long-term capital
gains when redeemed. This difference is quite meaningful since the maximum
tax rate on ordinary income in 2001 is 39.1% and on long-term capital gains is
20%. Thus, Brad may have good reason to reject phantom stock and SARs and
insist on the real thing.
Taxability of Stock Options
If Morris and Brad resolve their negotiations through the use of stock options,
careful tax analysis is again necessary. The Code treats stock options in three
ways depending on the circumstances, and some of these circumstances are
well within the control of the parties (see Exhibit 11.5).
If a stock option has a “readily ascertainable value,” the IRS will expect
the employee to include in his taxable income the difference between the
value of the option and the amount paid for it (the amount paid is normally
zero). Measured in that way, the value of an option might be quite small, espe-
cially if the exercise price is close or equal to the then fair market value of the
underlying stock. After all, the value of a right to buy $10 of stock for $10 is
only the speculative value of having that right when the underlying value has
increased. That amount is then taxed as ordinary compensation income, and
the employer receives a compensating deduction for compensation paid. When
the employee exercises the option, the Code imposes no tax, nor does the em-
ployer receive any further deduction. Finally, should the employee sell the
stock, the difference between, on the one hand, the price received and on the
other the total of the previously taxed income and the amounts paid for the op-
tion and the stock is included in his income as a capital gain. No deduction is
then granted to the employer since the employee’s decision to sell his stock is
not deemed to be related to the employer ’s compensation policy.
This taxation scenario is normally quite attractive to the employee be-
cause she is taxed upon a rather small amount at first, escapes tax entirely upon
EXHIBIT 11.5 Taxation of stock options.
Grant Exercise Sale
Readily Ascertainable Value
Employee Tax of value No tax Capital gain
Employer Deduction No deduction No deduction
No Readily Ascertainable Value
Employee No tax Tax on spread Capital gain
Employer No deduction Deduction No deduction
ISOP
Employee No tax No tax Capital gain
Employer No deduction No deduction No deduction