Non-qualified employee stock option plans:
Stock option plans are "non-qualified" if they do not meet the requirements of Internal Revenue Code Section 421. These options are also called "non-statutory." Cost basis treatment depends on whether the fair market value of the option is "readily ascertainable" on the date of the grant to the employee.
• Readily Ascertainable
If the fair market value of the option is readily ascertainable (i.e. actively traded on an established market), and the option is transferable, exercisable immediately, and has no significant restrictions, then the employee is taxed at ordinary income rates on the fair market value of the option (minus any cost paid) on the date of the grant. At exercise, the cost basis of the stock received is the sum of:
(1) the fair market value of the option at the date of the grant plus
(2) the exercise price paid for the stock.
No further income is recognized at the time the option is exercised. This is not so bad for a high growth stock because when the stock is sold, it is eligible for long-term capital gains treatment. The holding period begins the day after the option was exercised.
• Not Readily Ascertainable
The fair market value of the employee's non-qualified stock option may not be readily ascertainable because the options are not publicly-traded, are not transferable, are not exercisable immediately, or have conditions that would impact fair market value. In this case, the date of exercise determines the taxable event, rather than the date of the grant as in the "readily ascertainable" case above. At the time of exercise, ordinary income is recognized for the amount of the fair market value of the stock received less the cost of the option and less the exercise price paid. The cost basis for the stock acquired then becomes the fair market value of the stock at the date of exercise. The holding period for the stock starts the next day after the option is exercised.
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