Spicy Options for Restauranteur, Part 7
Case:
Roger Garcia is CEO of The Enchilada Factory, a chain of upscale restaurants that serves Mexican food geared toward health conscious patrons. Roger opened his first restaurant 30 years ago. With initial table space for a mere 12 people, Roger never could have imagined that this company would grow to over 150 locations with revenue of $800 million per year. Not surprisingly, magazines and trade journals frequently request interviews with Roger and write about his amazing journey to the top.However, it has not always been a smooth ride. The restaurant business is very competitive and there have been many difficult times over the years. For instance, about seven years ago, the company was on the verge of bankruptcy. Costs were soaring and customer service was abysmal. In need of new direction and new blood, Roger hired David Guerrero as President of the company. Not only did David have an amazing reputation for turning companies around, he had a restaurant business background. As expected, David pumped new life into The Enchilada Factory. He got costs under control, improved customer service and revamped the menu. In just two years, the company turned around and has never looked back.
This wonderful turnaround didn't come cheap, however. In order to acquire David, Roger gave him a substantial six figure salary and a plethora of incentive stock options (ISOs) - 10,000 ISOs to be exact. Given the current profitability and growth of the company, the stock price has skyrocketed in the past seven years. Accordingly, David's ISOs are worth a fortune.
After a thorough review of the characteristics of ISOs (see Parts 1-6), David asks about non-qualified stock options (NSOs). In particular, his wife Debra owns many NSOs at her company. Therefore, David wonders how they are similar and different from his ISOs.
Question:
What are the basic rules regarding NSOs? Does it cost anything to exercise NSOs? What are the tax consequences of receiving and exercising NSOs?Solution:
Stock options are a popular way to attract and retain key personnel. These options generally come in two types - incentive stock options (ISO) and non-qualified stock options (NSO). In many cases, NSOs are favored, because they are not subject to the numerous requirements of ISOs. Using NSOs, corporations may more easily reward key executives and officers.Similar to ISOs, there are generally no tax consequences to an employee when a NSO is granted. See Sec. 83. This allows a company to provide current benefits to an employee without an accompanying tax liability. There is an exception to this general rule. If the NSO has a readily ascertainable value, then the employee recipient may have taxable income immediately upon grant.
When Debra exercises or otherwise disposes of her NSO, it is a taxable event (unlike with an ISO). Specifically, Debra will realize ordinary income (not capital gain) equal to the difference between the exercise price and the fair market value of the stock. After the exercise of the options, many employees will sell a portion of the company stock in order to pay the tax liability triggered by the exercise. Since there is no favorable re-characterization of the company stock (from ordinary income to capital gain), there is no holding period requirement similar to ISOs. Thus, Debra could exercise the NSOs and sell the company stock immediately thereafter
After hearing the taxation details about NSOs, David is thankful for his ISOs. Given his high tax bracket, he especially likes the ability to convert his options from an ordinary income asset into a capital gain asset. Next, David wonders what charitable options Debra has with respect to her NSOs.
Editor's Note: In some cases, an employee may elect to report taxable compensation at the time the NSO is granted. See Sec. 83(b). The taxable income realized will equal the value of the stock options. With such an election, however, the employee will not report ordinary income upon later exercise of the option. This is not a common election because most employees do not want to increase their taxable income prematurely.