The popular perception of a stock option seems to be that of a golden envelope stuffed with cash. That's sometimes the case, such as when corporations offer top executives stock options at a deep discount or when start-up companies give workers stock options before going public. However, companies commonly grant options to their employees just because they want to sell more stock. Those are noncompensatory stock options.
The Basics of Options
A stock option is simply a contract that gives you the opportunity — the "option," that is — to buy shares of stock at a given price, called the strike price. You generally must exercise the option — actually purchase the stock — within a certain time frame. When a company grants options, it usually sets the strike price equal to the market price of the stock at the time of the grant. If the strike price is less than the market price at that time, the options are said to be discounted. The hope for people getting an option is that by the time they exercise the option, the market price will be higher than the strike price.
Compensatory vs. Non-Compensatory
Many companies give their employees stock options as a reward for past performance, or as an incentive for future performance. When this is the case, the options are part of the employee's compensation. That makes them, naturally, compensatory stock options. Still, a company may grant options simply because they want to raise more capital for the business, which, after all, is the whole point of selling stock in the first place. On the other hand, it may want to diversify its shareholder base. In such cases, the options aren't based on an employee's performance, so they're classified as noncompensatory.
The Accounting Angle
Whether an option is compensatory or noncompensatory has significant accounting implications. When a company grants compensatory options, it has to record an expense the same way it does with workers' regular wages. The exact amount it must report is often an enormously complicated calculation — if you want to make your eyes glaze over, look up "Black-Scholes options pricing model" sometime — but the upshot is that because compensatory options increase expenses, they reduce the company's net income, or the profit it reports to shareholders. Noncompensatory options, on the other hand, don't have to be reported as expenses and have no effect on profits. The company treats them like any other stock sale.
To keep companies from fudging things, accounting rules lay out standards that options have to meet to be noncompensatory. First, all workers who meet "limited employee qualifications" must be eligible for the options. It's up to the company to set those limited qualifications, but they commonly include such things as being a full-time worker or having been with the company a certain amount of time. Second, the options must be available to all eligible employees on an equal basis. This can mean that everyone has access to the same number of options, or that the number of options is based on a uniform percentage of pay. Third, the period during which employees can exercise their options has to be limited and must occur relatively soon after they receive the options. Finally, the discount on the option can't be any greater than what the company would offer to entice investors to buy into any other large stock offering.
If you're on the receiving end of noncompensatory stock options — or compensatory stock options, for that matter — you'd be well advised to check with a tax professional for advice. In general, though, receiving a noncompensatory option has no effect on your taxes. When you exercise that option, the difference between the strike price and the market price, if any, goes into the calculation to determine whether you must pay the federal Alternative Minimum Tax. When you sell the stock later, you pay capital gains tax on any profit you made off the sale.
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