Accounting and Tax Ramifications of Issuing Stock Options
Click here to view Part 1 of our series and learn more about the stock option landscape.
To give you more perspective, first let us review the accounting treatment for the issuance of stock options (rest easy – this will not be too painful). When stock options are issued, an expense must be recorded based on the value of the option. A stock option’s value is derived from a variety of factors, two of which are the value of the stock as of the date of the option grant and the exercise price of the option (the price at which the option holder can purchase a share of stock). Determining the value of a company’s stock is not difficult when it is publicly traded, but privately-held companies do not have readily available market prices, which necessitates the services of a valuation expert. Unless the option is properly valued, a company cannot correctly record the associated compensation expense. If a company is unable to correctly record the results of its operations, it may find obtaining a clean audit opinion to be a difficult, if not impossible, task.
Now that I have warned you about the headaches that you may encounter on the “accounting” side of issuing stock options, let me further alarm you with the tax ramifications. If a company sets the stock option exercise price lower than the fair market value of its stock on the grant date, the stock option could be deemed to be deferred compensation according to Internal Revenue Code 409A. Under 409A, such deferred compensation would be immediately taxable to the employees receiving the grant at ordinary income tax rates. Perhaps even more distressing, a 20% penalty calculated on the deferred compensation would also be triggered. In addition, employers would be responsible for withholding income taxes for employees on these types of option grants, which if not done, could result in additional tax penalties. The immediate taxability, penalty and withholding requirements of 409A do not apply when a stock option’s exercise price is equal to or greater than the fair market value of the company’s stock on the grant date. It is impossible to compare the exercise price of a stock option to the fair market value of a company’s stock unless a valuation of the company’s stock has been performed. In addition, when a valuation has been performed to establish the fair market value of a company’s stock, the burden of proof shifts to the IRS to disprove the appraised value. Therefore, unless there is documentation to support the fair market value of a company’s stock near the option grant date, there could be significant tax issues in addition to the accounting issues alluded to earlier.
The information in this article is not meant to represent legal or tax advice. Please consult with a Skoda Minotti business valuation professional or your tax/legal advisor regarding the applicability of these issues to your particular situation.
Visit us tomorrow for Part 3: What to Do?
In the meantime, visit our web site for more information on our financial reporting services. Skoda Minotti is a CPA, business and financial advisory firm with offices in Cleveland and Akron.