A qualified stock option, also known as employee stock options, is a share option given exclusively to a company's employees. Employees can exercise these options at a pre-specified strike price, unlike their fair market value. The strike is set at a beneficial price, making these tax incentivised stock options. The special tax treatment makes them 'qualified' stock options. Employees can exercise the option up till a pre-specified termination date.Summary
Stock options are given to employees as a part of their pay package. It is a type of alternative compensation offered to only a few employees. It gives them a sense of ownership while giving them tax and share ownerships benefits.
In the case of qualified stock options, an employee receives a tax benefit when the option is exercised, and an individual employee doesn't have to pay ordinary income tax. Instead, he is only taxed on the difference between the strike price and the fair market value of issued shares.
The taxation category application is dependent on the timeshares held for. When employee holds the shares for a year from exercise date or two years from the option grant date, they may get charged with a long-term capital gains tax. Such a tax is often lower than the prevailing income tax rate they would have paid on his cash salary. It makes the qualified stock options incentivised for employees.
Qualified stock options are offered with a pre-set strike price at or above the stock's market price on the date of issue. However, qualified stock options are not exercisable until several years in future and often expire after specific years of issuance or upon termination.
Image Source: © Olandah23 | Megapixl.com
Consider that shares of Magic Ltd are trading on ASX at AU$15. Now Magic Ltd launches an incentive scheme to reward employee efforts to grow a company. On the increase in the share price, qualified stock options are given with an AU$20 strike price exercisable after ten years. So, for example, if Magic Ltd.'s stock price is AU$25 after ten years, each of its rewarded employees holding qualified stock options can make a profit of AU$5 on choosing to exercise the option. Now, if an employee Z comes in a 30% income tax bracket, he will not precisely pay 30% on this gain. Instead, he will have to pay tax at the long-term capital gains rate, usually a lower tax bracket.
It is clear that qualified stock options do have favourable tax treatment; however, it involves a more extended holding period. A longer holding period makes it possible for the employees to benefit from the optimal tax treatment. However, an increased holding period does have an increased risk on the option price.
Qualified option holders may not exactly have to pay tax on the exercise date. However, the amount of the bargain element may attract an alternative minimum tax (AMT). Also, if these options are sold, they attract tax on the sale. However, there is a catch here, if options are sold as soon as exercise, the bargain element may get treated as regular income for the holders. Otherwise, if employees hold the stock for at least one year after exercising or don't sell them for at least two years from the option grant date, these will be taxed for long term gains at lower rates.
An employee stock option must fulfil the following conditions to qualify for the special tax treatment.
The significant difference is based on the tax treatment, making qualified stock options unique from non-qualified stock options.
Source: © Raducomes | Megapixl.com
Corporations grant stock options only to a few deserving employees, that to a fixed exercise price. When employees exercise the options, the employer organisation claims a tax deduction for the difference between the fair market value and the exercise price. However, the amount is taxable to the employees.
In the case of a qualified stock option, the exercise price cannot be lower than the fair market value at the time of issue. Non-qualified options do not have any such restrictions.