the employee' s income inclusion. The employer is required to withhold income and employment taxes on the employee' s income amount. For the employee: In general, there is no taxable income to the employee at the time of grant. However, the difference between the value of the stock at exercise and the exercise price is ordinary income to the employee at the time of exercise. The income recognized on exercise is subject to income tax withholding and to employment taxes. When the stock is later sold, the gain or loss is capital gain or loss (calculated as the difference between the sales price and tax basis, which is the sum of the exercise price and the income recognized at exercise).

Accounting Treatment of ISOs and NSOs

Generally, under traditional rules, there is no charge to earnings for accounting purposes, unless the option is granted with an option price of less than the fair market value of the stock, determined at the date of grant (the measurement date). For companies contemplating an IPO within the foreseeable future, the valuation of stock option grants can be particularly important, as the SEC commonly questions the exercise prices of options granted in the period before the IPO.

Certain conditions, however, may result in an earnings charge if there is a stock value/exercise price disparity at some other measurement date. The ex

Set forth below is an overview of the tax, accounting and general business considerations applicable to typical equity based compensation arrangements. Following the overview are general descriptions of how those considerations apply to three basic types of arrangements: incentive stock options; non-qualified stock options; and restricted stock.

Incentive Stock Options (ISOs) Offer Great Tax Benefits, but Are for Employees Only

An incentive stock option ("ISO") provides for the grant to employees only (not to outside directors, consultants, etc.) of options to acquire stock of the employer and, by satisfying a series of statutory requirements, qualifies for a specified set of tax consequences. To satisfy tax requirements, the plan providing for the grant of the ISOs must be approved by the shareholders within 12 months before or after it is adopted, must specify the aggregate number of shares of employer stock that are available for issuance under the plan and must specify the employees or class of employee eligible for the plan.

The restrictions applicable to terms of the ISO are:

* the option price must at least equal the fair market value of the stock at the time of grant;
* the option cannot be transferable, except at death;
* there is a $100,000 limit on the aggregate fair market value (determined at the time the option is granted) of stock which may be acquired by any employee during any calendar year (any amount exceeding the limit is treated as a nonqualified stock option, as described below);
* all options must be granted within 10 years of plan adoption or approval of the plan, whichever is earlier;
* the options must be exercised within 10 years of grant;
* the options must be exercised within three months of termination of employment (extended to one year for disability retirement, with no time limit in the case of death);
* optimum tax treatment to the employee depends on the employee not making a 'Disqualifying Disposition' (i.e., the employee does not dispose of the shares within 2 years after the date of grant of the option or within 1 year of receipt of the shares).

Modification of an existing option is treated as a grant of a new option, which must meet all of the applicable tax requirements as of the date of the modification. Note that, in the case of a 10 percent or greater shareholder, the option price must be at least 110 percent of the fair market value of the stock at time of grant and the option period must not exceed 5 years. The number of options granted to each employee at any one time can be discretionary. The exercisability of options typically vests over time. Vesting can be conditioned on performance, in addition to continued employment. The plan may permit the option price to be paid with other stock held by the employee. If stock previously received on exercise of another ISO is used to exercise an ISO, the disposition of the previously held shares will be nontaxable unless it is a Disqualifying Disposition.

Tax Consequences of ISOs

For the employer: No compensation deduction is ever allowed with for an ISO, unless the employee makes a Disqualifying Disposition, in which case the employer receives a deduction equal to the employee' s income inclusion for the year in which the Disqualifying Disposition occurs. Under current rules, the employer is not required to withhold income or employment taxes, even in the case of a Disqualifying Disposition. For the employee: There is no taxable income to the employee at the time of grant or timely exercise. However, the difference between the value of the stock at exercise and the exercise price is an item of adjustment for purposes of the dreaded alternative minimum tax ('AMT'). In the absence of a Disqualifying Disposition, gain or loss when the stock is later sold is long-term capital gain or loss. Gain or loss is the difference between the amount realized from the sale and the tax basis (i.e., the amount paid on exercise). In the case of a Disqualifying Disposition, the employee is treated as having ordinary income subject to tax in an amount equal to the lesser of (i) the difference between the amount realized on the disposition and the exercise price, or (ii) the difference between the fair market value of the stock on the date the ISO is exercised and the exercise price. Any gain in excess of the amount taxed as ordinary income will be treated as a long or short-term capital gain depending on whether the stock was held for more than twelve months.

Nonqualified Stock Options (NSOs): The Leftovers

In general, Nonqualified Stock Options ('NSOs'), unlike ISOs, are not subject to specific tax eligibility requirements an NSO is just a plain old option. Thus, any option that is not an ISO is by default an NSO. The term 'nonqualified' means just that if the option does not qualify as an ISO, it' s a stock option that enjoys no special tax treatment. NSOs are typically granted with an exercise price approximating the value of the stock at the time of grant, although they are frequently issued at some discount from such value. Like ISOs, NSOs may become exercisable as they vest over time, conditioned on continued employment or specific performance criteria. Unlike ISOs, NSOs can be issued to anyone, employee or otherwise.

Tax Consequences of NSOs

For the employer: In general, the employer receives a deduction equal to (and at the same time as) the employee' s income inclusion. The employer is required to withhold income and employment taxes on the employee' s income amount. For the employee: In general, there is no taxable income to the employee at the time of grant. However, the difference between the value of the stock at exercise and the exercise price is ordinary income to the employee at the time of exercise. The income recognized on exercise is subject to income tax withholding and to employment taxes. When the stock is later sold, the gain or loss is capital gain or loss (calculated as the difference between the sales price and tax basis, which is the sum of the exercise price and the income recognized at exercise).

Accounting Treatment of ISOs and NSOs

Generally, under traditional rules, there is no charge to earnings for accounting purposes, unless the option is granted with an option price of less than the fair market value of the stock, determined at the date of grant (the measurement date). For companies contemplating an IPO within the foreseeable future, the valuation of stock option grants can be particularly important, as the SEC commonly questions the exercise prices of options granted in the period before the IPO.

Certain conditions, however, may result in an earnings charge if there is a stock value/exercise price disparity at some other measurement date. The ex

he time the option is granted) of stock which may be acquired by any employee during any calendar year (any amount exceeding the limit is treated as a nonqualified stock option, as described below);
* all options must be granted within 10 years of plan adoption or approval of the plan, whichever is earlier;
* the options must be exercised within 10 years of grant;
* the options must be exercised within three months of termination of employment (extended to one year for disability retirement, with no time limit in the case of death);
* optimum tax treatment to the employee depends on the employee not making a 'Disqualifying Disposition' (i.e., the employee does not dispose of the shares within 2 years after the date of grant of the option or within 1 year of receipt of the shares).

Modification of an existing option is treated as a grant of a new option, which must meet all of the applicable tax requirements as of the date of the modification. Note that, in the case of a 10 percent or greater shareholder, the option price must be at least 110 percent of the fair market value of the stock at time of grant and the option period must not exceed 5 years. The number of options granted to each employee at any one time can be discretionary. The exercisability of options typically vests over time. Vesting can be conditioned on performance, in addition to continued employment. The plan may permit the option price to be paid with other stock held by the employee. If stock previously received on exercise of another ISO is used to exercise an ISO, the disposition of the previously held shares will be nontaxable unless it is a Disqualifying Disposition.

Tax Consequences of ISOs

For the employer: No compensation deduction is ever allowed with for an ISO, unless the employee makes a Disqualifying Disposition, in which case the employer receives a deduction equal to the employee' s income inclusion for the year in which the Disqualifying Disposition occurs. Under current rules, the employer is not required to withhold income or employment taxes, even in the case of a Disqualifying Disposition. For the employee: There is no taxable income to the employee at the time of grant or timely exercise. However, the difference between the value of the stock at exercise and the exercise price is an item of adjustment for purposes of the dreaded alternative minimum tax ('AMT'). In the absence of a Disqualifying Disposition, gain or loss when the stock is later sold is long-term capital gain or loss. Gain or loss is the difference between the amount realized from the sale and the tax basis (i.e., the amount paid on exercise). In the case of a Disqualifying Disposition, the employee is treated as having ordinary income subject to tax in an amount equal to the lesser of (i) the difference between the amount realized on the disposition and the exercise price, or (ii) the difference between the fair market value of the stock on the date the ISO is exercised and the exercise price. Any gain in excess of the amount taxed as ordinary income will be treated as a long or short-term capital gain depending on whether the stock was held for more than twelve months.

Nonqualified Stock Options (NSOs): The Leftovers

In general, Nonqualified Stock Options ('NSOs'), unlike ISOs, are not subject to specific tax eligibility requirements an NSO is just a plain old option. Thus, any option that is not an ISO is by default an NSO. The term 'nonqualified' means just that if the option does not qualify as an ISO, it' s a stock option that enjoys no special tax treatment. NSOs are typically granted with an exercise price approximating the value of the stock at the time of grant, although they are frequently issued at some discount from such value. Like ISOs, NSOs may become exercisable as they vest over time, conditioned on continued employment or specific performance criteria. Unlike ISOs, NSOs can be issued to anyone, employee or otherwise.

Tax Consequences of NSOs

For the employer: In general, the employer receives a deduction equal to (and at the same time as) the employee' s income inclusion. The employer is required to withhold income and employment taxes on the employee' s income amount. For the employee: In general, there is no taxable income to the employee at the time of grant. However, the difference between the value of the stock at exercise and the exercise price is ordinary income to the employee at the time of exercise. The income recognized on exercise is subject to income tax withholding and to employment taxes. When the stock is later sold, the gain or loss is capital gain or loss (calculated as the difference between the sales price and tax basis, which is the sum of the exercise price and the income recognized at exercise).

Accounting Treatment of ISOs and NSOs

Generally, under traditional rules, there is no charge to earnings for accounting purposes, unless the option is granted with an option price of less than the fair market value of the stock, determined at the date of grant (the measurement date). For companies contemplating an IPO within the foreseeable future, the valuation of stock option grants can be particularly important, as the SEC commonly questions the exercise prices of options granted in the period before the IPO.

Certain conditions, however, may result in an earnings charge if there is a stock value/exercise price disparity at some other measurement date. The ex

nued employment. The plan may permit the option price to be paid with other stock held by the employee. If stock previously received on exercise of another ISO is used to exercise an ISO, the disposition of the previously held shares will be nontaxable unless it is a Disqualifying Disposition.

Tax Consequences of ISOs

For the employer: No compensation deduction is ever allowed with for an ISO, unless the employee makes a Disqualifying Disposition, in which case the employer receives a deduction equal to the employee' s income inclusion for the year in which the Disqualifying Disposition occurs. Under current rules, the employer is not required to withhold income or employment taxes, even in the case of a Disqualifying Disposition. For the employee: There is no taxable income to the employee at the time of grant or timely exercise. However, the difference between the value of the stock at exercise and the exercise price is an item of adjustment for purposes of the dreaded alternative minimum tax ('AMT'). In the absence of a Disqualifying Disposition, gain or loss when the stock is later sold is long-term capital gain or loss. Gain or loss is the difference between the amount realized from the sale and the tax basis (i.e., the amount paid on exercise). In the case of a Disqualifying Disposition, the employee is treated as having ordinary income subject to tax in an amount equal to the lesser of (i) the difference between the amount realized on the disposition and the exercise price, or (ii) the difference between the fair market value of the stock on the date the ISO is exercised and the exercise price. Any gain in excess of the amount taxed as ordinary income will be treated as a long or short-term capital gain depending on whether the stock was held for more than twelve months.

Nonqualified Stock Options (NSOs): The Leftovers

In general, Nonqualified Stock Options ('NSOs'), unlike ISOs, are not subject to specific tax eligibility requirements an NSO is just a plain old option. Thus, any option that is not an ISO is by default an NSO. The term 'nonqualified' means just that if the option does not qualify as an ISO, it' s a stock option that enjoys no special tax treatment. NSOs are typically granted with an exercise price approximating the value of the stock at the time of grant, although they are frequently issued at some discount from such value. Like ISOs, NSOs may become exercisable as they vest over time, conditioned on continued employment or specific performance criteria. Unlike ISOs, NSOs can be issued to anyone, employee or otherwise.

Tax Consequences of NSOs

For the employer: In general, the employer receives a deduction equal to (and at the same time as) the employee' s income inclusion. The employer is required to withhold income and employment taxes on the employee' s income amount. For the employee: In general, there is no taxable income to the employee at the time of grant. However, the difference between the value of the stock at exercise and the exercise price is ordinary income to the employee at the time of exercise. The income recognized on exercise is subject to income tax withholding and to employment taxes. When the stock is later sold, the gain or loss is capital gain or loss (calculated as the difference between the sales price and tax basis, which is the sum of the exercise price and the income recognized at exercise).

Accounting Treatment of ISOs and NSOs

Generally, under traditional rules, there is no charge to earnings for accounting purposes, unless the option is granted with an option price of less than the fair market value of the stock, determined at the date of grant (the measurement date). For companies contemplating an IPO within the foreseeable future, the valuation of stock option grants can be particularly important, as the SEC commonly questions the exercise prices of options granted in the period before the IPO.

Certain conditions, however, may result in an earnings charge if there is a stock value/exercise price disparity at some other measurement date. The ex

t to tax in an amount equal to the lesser of (i) the difference between the amount realized on the disposition and the exercise price, or (ii) the difference between the fair market value of the stock on the date the ISO is exercised and the exercise price. Any gain in excess of the amount taxed as ordinary income will be treated as a long or short-term capital gain depending on whether the stock was held for more than twelve months.

Nonqualified Stock Options (NSOs): The Leftovers

In general, Nonqualified Stock Options ('NSOs'), unlike ISOs, are not subject to specific tax eligibility requirements an NSO is just a plain old option. Thus, any option that is not an ISO is by default an NSO. The term 'nonqualified' means just that if the option does not qualify as an ISO, it' s a stock option that enjoys no special tax treatment. NSOs are typically granted with an exercise price approximating the value of the stock at the time of grant, although they are frequently issued at some discount from such value. Like ISOs, NSOs may become exercisable as they vest over time, conditioned on continued employment or specific performance criteria. Unlike ISOs, NSOs can be issued to anyone, employee or otherwise.

Tax Consequences of NSOs

For the employer: In general, the employer receives a deduction equal to (and at the same time as) the employee' s income inclusion. The employer is required to withhold income and employment taxes on the employee' s income amount. For the employee: In general, there is no taxable income to the employee at the time of grant. However, the difference between the value of the stock at exercise and the exercise price is ordinary income to the employee at the time of exercise. The income recognized on exercise is subject to income tax withholding and to employment taxes. When the stock is later sold, the gain or loss is capital gain or loss (calculated as the difference between the sales price and tax basis, which is the sum of the exercise price and the income recognized at exercise).

Accounting Treatment of ISOs and NSOs

Generally, under traditional rules, there is no charge to earnings for accounting purposes, unless the option is granted with an option price of less than the fair market value of the stock, determined at the date of grant (the measurement date). For companies contemplating an IPO within the foreseeable future, the valuation of stock option grants can be particularly important, as the SEC commonly questions the exercise prices of options granted in the period before the IPO.

Certain conditions, however, may result in an earnings charge if there is a stock value/exercise price disparity at some other measurement date. The ex

the employee' s income inclusion. The employer is required to withhold income and employment taxes on the employee' s income amount. For the employee: In general, there is no taxable income to the employee at the time of grant. However, the difference between the value of the stock at exercise and the exercise price is ordinary income to the employee at the time of exercise. The income recognized on exercise is subject to income tax withholding and to employment taxes. When the stock is later sold, the gain or loss is capital gain or loss (calculated as the difference between the sales price and tax basis, which is the sum of the exercise price and the income recognized at exercise).

Accounting Treatment of ISOs and NSOs

Generally, under traditional rules, there is no charge to earnings for accounting purposes, unless the option is granted with an option price of less than the fair market value of the stock, determined at the date of grant (the measurement date). For companies contemplating an IPO within the foreseeable future, the valuation of stock option grants can be particularly important, as the SEC commonly questions the exercise prices of options granted in the period before the IPO.

Certain conditions, however, may result in an earnings charge if there is a stock value/exercise price disparity at some other measurement date. The exercise of an option with stock already held can result in the earnings charge being calculated at the exercise date if the stock used to exercise the option has been held less than six months. Withholding of stock upon exercise will not result in a new measurement date if the withheld stock is limited to the minimum withholding tax payable by the employee. Withholding of more shares can result in the exercise date becoming a new measurement date for the withheld shares. A cash bonus to pay withholding taxes can result in the exercise date becoming a new measurement date for the option as well as the cash bonus itself. Under rules adopted by the Financial Accounting Standards Board, companies are 'encouraged' to account for equity based compensation awards based on the fair value of the awards; companies that do not do so nonetheless must disclose such fair value in notes to their financial statements. We believe that most public companies choose the latter approach.

The accounting treatment of option grants to non-employees has recently changed. Grants to non-employees will now incur a compensation expense for the company (other than grants to non-employee directors, who for this purpose are treated as employees), even if the option price is set at the fair market value of the stock at the time of grant.

And if You Remember Nothing Else...

Incentive Stock Option (ISO)Non-Qualified Stock Option (NSO) Tax Qualification Requirements?:ManyNoneWho Can Receive?Employees OnlyAnyoneHow Taxed for Employee:* There is no taxable income to the employee at the time of grant or timely exercise.

* However, the difference between the value of the stock at exercise and the exercise price is an item of adjustment for purposes of the alternative minimum tax ("AMT").

* Gain or loss when the stock is later sold is long-term capital gain or loss. Gain or loss is the difference between the amount realized from the sale and the tax basis (i.e., the amount paid on exercise).

* Disqualifying Disposition destroys favorable tax treatment.* The difference between the value of the stock at exercise and the exercise price is ordinary income.

* The income recognized on exercise is subject to income tax withholding and to employment taxes.

* When the stock is later sold, the gain or loss is capital gain or loss (calculated as the difference between the sales price and tax basis, which is the sum of the exercise price and the income recognized at exercise).