Statutory Stock Option

What Is a Statutory Stock Option?

The term statutory stock option refers to a type of employee stock option (ESO). These plans are offered to employees by corporations as a form of compensation—one that's in addition to their salary. They are used as a way to attract and retain talent and provide participants with an additional tax advantage.

This type of employee compensation may be compared with incentive stock options (ISOs), which are only handed out to the top members of management for retention or to reward performance. As such, these plans are different from unqualified or nonstatutory stock options.

Key Takeaways

  • Statutory stock options are a type of compensation offered by employers to their employees.
  • These plans must come with a document denoting how many options are allotted to which employees.
  • Statutory stock options provide an additional tax advantage not offered by unqualified or nonstatutory stock options.
  • Employees must exercise statutory stock options after a vesting period, which may be as long as 10 years after they are issued.
  • The exercise of these options does not result in immediate declarable taxable income.

How Statutory Stock Options Work

Many employers provide perks such as statutory stock options to their employees. Also referred to as incentive stock options (ISOs), they are used as a way to attract potential new employees or encourage existing employees to remain with the company. The offering company essentially shares a portion of its profits with its employees. This gives participating staff an extra incentive to ensure the company succeeds while receiving compensation on top of their regular salary.

Statutory stock options require a plan document that clearly outlines how many options are given to employees. Those employees must exercise their options within 10 years of receiving them. The exercise or strike price cannot be less than the market price of the stock when it is granted. Statutory stock options cannot be sold until at least a year after the exercise date and two years after the date the option is granted.

The taxation of statutory stock options can be somewhat complicated. The exercise of statutory stock options will not result in immediate declarable taxable income to the employee—one of the chief advantages of this type of option. The capital gains tax is paid later on the difference between the exercise and sale price. This type of option is also considered one of the preference items for the alternative minimum tax.

According to the Internal Revenue Service (IRS), when employers grant statutory stock options, employees typically do not have to include any amount in their gross income when they receive or exercise the option. Despite that fact, employees who receive a statutory stock option may fall under the alternative minimum tax for the year in which their statutory stock options are exercised.

There is a vesting period that must take place before employees can exercise these options. This period is usually longer than non-qualified stock options or the tax implications increase.

Special Considerations

When the stock acquired through exercising the option is later sold, the employee will have taxable income or a deductible loss as a result. This is typically rated as a capital gain or loss. The assumption is that the price of the stock option will be lower than the market price at the time the option is exercised, which would allow the employee to possibly sell the asset for a profit.

If the employee does not meet special holding-period requirements—meaning they sold the shares before one year passed since the exercise date—the income from that sale must be handled as ordinary income. That amount is also added to the basis of the stock in order to calculate the loss or gain on the disposition of the stock.

With an employee stock purchase plan, after the stock acquired by exercising an option is transferred or sold for the first time, employees should furnish forms from their employer that include information for determining the ordinary and capital income that must be reported.

What Is Stock Option Compensation?

Stock option compensation is a way companies reward employees that is in addition to their base salary and benefits. These options give the employee the right to purchase the company's stock at a later date for a specified price. The vesting period is the number of years the employee must remain with the company before they can exercise their stock options.

Startup companies often use stock option compensation when recruiting new employees to work for their firms. This gives employees the opportunity to share in the company's future growth while simultaneously enabling the startup to control labor costs.

How Are Statutory Stock Options Taxed?

An employee who receives statutory stock options from their employer does not incur any immediate tax obligation. They will owe taxes only if they exercise their stock options and then sell the stock.

Additionally, if an employee exercises their stock options, they will not incur any taxes as long as they hold the stock in the year they acquire it. If the employee sells the stock acquired through the stock options, they will have income from the sale that will be subject to income taxes. Depending on when the employee exercises the options and sells the stock, they may have an adjustment to their taxes due to the impact of the alternative minimum tax rules.

What Are Nonstatutory Stock Options?

Nonstatutory stock options are a type of stock option granted by an employer to an employee that allows the employee to buy the company's stock at a preset price at a later date. Unlike statutory stock options, nonstatutory stock options are not part of an employee stock purchase plan or incentive stock option plan. Also known as non-qualified stock options, nonstatutory stock options have different tax rules than statutory stock options.

How Are Nonstatutory Stock Options Taxed?

Nonstatutory stock options may trigger a taxable event at three different stages. First, the receipt of the stock options is taxable if it's possible to determine the fair market value of the options.

Second, if you exercise the option, you'll report on your W2 the fair market value of the stock minus the amount you actually paid. This is reported as ordinary wage income and will increase your tax basis. Lastly, if you sell the stock you acquired through the option, you'll need to report the capital gain or loss for the difference between your tax basis and what you received on the sale.

Article Sources
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  1. Internal Revenue Service. "Topic No. 427 Stock Options." Accessed Dec. 8, 2021. 

  2. Internal Revenue Service. "Publication 525, Taxable and Nontaxable Income," Page 12. Accessed Dec. 8, 2021.

  3. Internal Revenue Service. "Publication 525, Taxable and Nontaxable Income," Pages 11–12. Accessed Dec. 8, 2021.

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