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United States Legal Considerations Related to Employee Stock Option Grants

Stock options may be a valuable component in the compensation mix for US employees in US-based operations. Extreme care must be exercised in granting stock options to ensure compliance with federal tax laws and federal and state securities laws.  

Stock options grant a right to acquire shares of the issuer’s stock for a stated price upon satisfaction of stated vesting requirements. Incentive stock options (ISOs) are not taxed on grant or on exercise of the option, but certain government information reporting requirements must be provided for the year of exercise. Taxes on ISOs are delayed until the sale of the underlying shares. A lower capital gains tax rate applies to ISOs if the required holding periods for the shares are satisfied.  Similar to ISOs, nonstatutory stock options (NSOs) are not subject to tax on grant, but taxes are imposed on exercise of the option and again when the shares of stock are sold. Withholding tax obligations apply if the optionee is an employee of the issuer or its subsidiary. 

Only employees of the parent organization issuing the options or employees of a subsidiary may be granted ISOs. The options granted must be exercised in limited, statutorily-prescribed time periods.  Options must be granted at fair market value pursuant to a written plan that includes the aggregate number of shares issuable as ISOs, specifies the employees eligible for those grants and is approved by the stockholders of the issuer within 12 months of the date the plan is adopted by the board of directors. Other requirements also apply, however, the stockholder approval requirement is one that may commonly not be achieved with a non-US issuer since ISOs may not have been contemplated when the plan was approved. If this is case, a sub-plan for US employees can be adopted by the board of directors and approved by the stockholders.

Due to Internal Revenue Code Section 409A, it is also imperative that options be issued at fair market value (FMV). NSOs issued below-FMV that fail to limit exercisability to the permissible events designated in Section 409A are taxed on the date of grant at regular income rates plus an additional 20%. Options that are intended to be ISOs, but are not priced at FMV are disqualified from ISO classification and are instead treated as NSOs. As such, the issuing entity must take great care to consider whether its valuation efforts comply with Section 409A.

Another facet of stock options that requires attention is federal and state securities law compliance. Rule 701 of the Securities Act of 1933 exempts stock options from federal registration if grants are made pursuant to a written plan established by the issuer for the benefit of its employees or employees of a subsidiary, but there are limitations on the number of securities issuable.  Issuers should also be aware that state securities laws vary. Consequently, compliance with the laws of the state in which an optionee resides should be verified before an option grant is made.