A
stock option plan is that type of a plan in which the employees of a particular company are given the benefit of buying a particular number of stock options of the same company for a specific period of time.
The exercise price of these options matches the market price of these options when they are offered.
Usually, there are two methods with the help of which the employees can enjoy partial ownership of the company and participate in its growth. The methods are stock option plans and stock ownership plans. They both have similar characteristics, but they are not exactly the same.
The employee stock ownership plan is also known as ESOP. This is basically a retirement plan, which carries defined contributions and is tax-qualified in nature. This plan enables the employees of a particular company to become partial owners. The employer sponsors the contributions and they increase in a tax-deferred manner similar to the Individual Retirement Account (IRA) or 401(k). However, the difference between this plan and other retirement plans is that the contribution has to go into the stocks of the company.
The advantages derived by the company from these kinds of plan are the following:
- Savings in taxation
- Increasing cash flow
- Improved productivity from the inspired employees
The employees are able to participate in the growth of the company and this is the principal advantage of stock option plan.
The employee stock option plan allows an employee of a particular company to avail the right to purchase a particular number of shares of the employer at a fixed price (which is known as the strike price, grant price or the exercise price) within a particular period of time, such as 10 years. Stock option plans are often called as employee stock options or ESOs and they are applied to both private and public sector companies.
The employee stock options are usually categorized into the following two types:
- Incentive Stock Options (ISOs)
- Nonqualified Stock Options (NSOs)
The incentive stock options are also called as statutory options or qualified options. At the time of their allotment or exercising, no income tax is charged. Rather, the taxation is deferred till the time of selling the stock and the entire profit is taxed.
In case of nonqualified stock options, there is no tax liability on the employee at the time of allotment, however, ordinary income tax is payable on the profit gained at the time of exercising the options. The company will deduce the tax amount as compensation expenditure.
The three fundamental methods for exercising the options are the following:
- Cashless exercise
- Pay cash
- Stock swap