Admin Super Powers: Stock Option Plan Administration – Part 4, Exercise and Forfeiture

Now that we’ve covered the basics on stock option grants, vesting, and terminations, the conversation gets a bit more technical. Stock plan administration covers four core areas of knowledge – administration, corporate and securities law, tax regulations, and accounting standards. At some point, your company will get big enough or your stock plan will get complicated enough that you’ll want a more in-depth knowledge of these areas and the best way to do that is to become a Certified Equity Professional. Until then, the most important thing is to know what to expect and when a red flag should be raised.

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Exercise – Buying Company Stock at a Discount

Stock and option awards are granted as an incentive to attract highly skilled workers and to allow early employees to share in the growth of the company and the increase in the value of its stock. That increase or gain – the difference between the award exercise price and the fair market value of the company’s stock on the date of exercise – is income to the new stockholder. The underlying award type will determine what you, as an administrator, should expect to happen on the exercise date.

Tax-qualified Incentive Stock Option:

  • The employee will be able to avoid ordinary income taxes on the gain, but should talk to his or her personal tax professional regarding Alternative Minimum Tax consequences.
  • The company must report the exercise to the IRS on a Form 3921 by February of the next calendar year (and copy the employee) or suffer heavy penalties.
  • The company must track when the stock is eventually sold to make sure the employee meets the required holding periods (2 years after grant and 1 year after exercise).

Non-qualified Stock Option:

  • The gain is taxable immediately as ordinary income.
  • The company must collect withholding taxes and report the income to an employee on a W-2, and must report on a 1099-MISC for a non-employee (no withholding required).
  • The company is allowed to take a tax deduction for the amount of the income reported.

Forfeit – But Not Lost!

Sometimes an employee will leave the company before an option vests or will fail to exercise vested options before the post-termination exercise period expires. Those shares are then forfeit. Two important things happen to forfeit shares:

  • The shares return to the stock plan’s reserve pool and become available for new grants (this will show up on your company’s cap table).
  • The forfeitures will be used by your CFO as one factor in determining how much estimated compensation expense is booked for future awards.

These are highlights of how a simple exercise or forfeiture can have tax or accounting consequences. Knowing about them will help you look stellar in your CFO’s eyes.

Making sure that you have processes in place to track grants, exits, and exercises will ensure that you stay on top of this complex benefit plan. Next month we’ll look at plan administration best practices in Admin Super Powers.

Achaessa James has worked in equity compensation since 1999 in the legal, venture capital, and equity administration outsourcing fields. She is a senior Equity Compensation Consultant with Stock & Option Solutions where she supports clients with system implementations, data migrations, corporate governance audits, corporate transaction preparation, and special project design and implementation.   She is also the consulting Equity Compensation Product Manager for the National Center for Employee Ownership where she manages the highly regarded twice-yearly CEP Exam Prep Course, and serves as the NCEO’s subject matter expert on equity compensation.

Achaessa’s focus on privately held companies has earned her a deep expertise in pre-IPO and M&A equity planning and audits, and best practices in administration and technology. She speaks on these topics at industry conferences and in webcasts, and is a published author with books including “If I’d Only Known That!”, and “The Private Company Equity Compensation Administration Toolkit” as well as many newsletter articles in industry publications. You can connect with Achaessa on LinkedIn.


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