 Hello and welcome to this session. This is Professor Farhad in which we will discuss employee stock options. First we need to understand the basic idea of employee stock options and how do they work. Now this topic is close to my heart because my first job after my undergraduate degree in finance was dealing with employee stock options. I work in a firm where we handled employee stock options for certain companies. So let's go ahead and explain to you how employee stock options work. So let's assume you work for a company like Intel and indeed I handled stock options for Intel, Intel company specifically for this company. And let's assume Intel stock price today. I don't know what the stock price is. Let's assume it's $25 which is for the sake of illustration and you work for Intel. They might give you 1000 options for example here. They might give you 1000 options to buy it at $40. Now you might be saying well that's useless. Indeed that's useless because you can buy Intel at market for $25. But here's what they did. They will give you these options and they would say you have 10 years to exercise. So you don't have to exercise your option today. In the next 10 years if the price goes above $40 you are, you'll be in good shape. Now this when they grant it to you this is called the just terminology important the grant date. So this is the date that they give it to you. Now also usually for companies they will have what's called vested period. For example you have to stay for the company two years before you qualify to exercise the options. In other words you have to work for the company to earn it. So let's fast forward two years. Now you are vested. You qualify to buy the stock and Intel stock happens to be trading now at $50. Well if it's trading at $50 your options are in the money. What does it mean in the money? It means your options are worth something. You can buy Intel at $40 and immediately sell it for $50 and make a $10 profit. So your option is in the money. Now if the price was trading at let's assume $38 you will be out of the money because your option does not have any value. Your option is in the money. Now if you decided to exercise this is called the exercise date. It's the day that you actually buy the stock at the strike price and you would only do that if the exercise price is greater than the grant price which is the strike price of $40. So otherwise the option is useless. Now after you exercise you can sell. You can sell immediately or you can sell the stock in the future. Basically you own the stock. So this is the basic idea of stock options. There's the grand date, there's the exercise date and eventually there's the sell date. Now the sell date and the exercise date could be the same. People exercise and sell immediately. People exercise and hold their stock. There are different consequences depending on what type of options you have. Before we proceed any further I have a public announcement about my company farhatlectures.com. Farhat Accounting Lectures is a supplemental educational tool that's going to help you with your CPA exam preparation as well as your accounting courses. My CPA material is aligned with your CPA review course such as Becker, Roger, Wiley, Gleam, Miles. My accounting courses are aligned with your accounting courses broken down by chapter and topics. My resources consist of lectures, multiple choice questions, true-false questions as well as exercises. Go ahead start your free trial today. No obligation, no credit card required. So let's talk about the different type of options. You could have non-qualified stock options. You could have qualified stock options. Non-qualified stock options, we could have two types. Non-qualified stock options, we could have options with readily determinable value which it means they have a fair market value that's known. We're dealing here with public companies or we have non-qualified stock option that don't have a fair value. Here we are dealing with private companies, companies that their stock is not publicly traded. And under qualified stock options we have incentive stock options, we have employee stock purchase plans, plan, not plans. Now what's going to happen is in this session I'm going to deal with non-qualified stock options. And what are non-qualified stock options? If it's not qualified, it's non-qualified. And what is qualified? We'll deal with qualified next session. Just know non-qualified is something that's not qualified. Okay? So any stock option that does not meet the qualification of a qualified stock options, which we'll talk about next, will be a non-qualified. Now what do we need to know about non-qualified stock options? If the option have readily determinable value, remember we have two types of them, we're going to start with readily determinable value. On the grand date, now we know what the grand date is, the stock is taxed on the grand date. So as soon as they grant you this option, if there's readily determinable price, you are taxed right there. So the employees recognize an ordinary income for the difference between the fair value of the option and any cost. So you might have to incur some cost to buy those shares. If there's any cost, that's going to be deducted. So notice it's ordinary income and it's right on the grand date. So as soon as they grant you the option, it's the fair value of the option minus any cost. And there is no AMT here, just FYI because we're going to talk about alternative minimum tax and the incentive stock options because it's ordinary income, it's already ordinary income. Now since you already kind of paid taxes on the stock, what's going to happen? The basis of the stock equal to the sum of the exercise price and the sum of the taxes paid. Remember, you treated it as ordinary income and you paid taxes on that stock. What's going to happen is your basis, it's equal to the exercise price, whatever the exercise price is and the amount of taxes that you paid. And don't worry, we'll work an example because you pay taxes, basically you are buying the stock, although you didn't get the stock, but you have to pay taxes because the stock options has a, it's a non-qualify and it's, it has a readily determinable value. So you have to pay the taxes upfront. That's the bad news, the good news, the taxes becomes part of your basis. So taxes plus exercise price equal to your basis. Now when you sell it down the road, when you sell this, this stock down the road, you're going to either have a capital gain or a capital loss. If you sold it, more than the, more than the exercise price and the amount tax, you'll have a capital gain. If you sell it less, you have a loss. Don't worry, we're going to work an example with numbers. If the option laps, what does that mean? Let's assume the option was always out of the money. In other words, you don't exercise it because remember the Intel example, if the stock of Intel never exceeds $40, you just let it go. It's, it's worthless. The employer recognized a capital loss for the value of the option that was previously taxed as ordinary income. So whatever the value was, now it's considered ordinary income loss and it's deducted against your ordinary income. It's a capital loss, which is good. On the other hand, this is, we're talking about the employee, what about the employer? The employer generally deduct an ordinary business expense for the fair value of the stock options in the tax year in which the employee were required to recognize an ordinary income. So when the employer recognized an ordinary income, the company will have a tax deduction. The best way to illustrate this is to look at an example. On March 15th, year one, John received a non-qualified stock options as follows. Number of shares to be purchased, 500. The exercise price is 10. The fair value of the option on the great grand date is two. So we know the fair value of the option. Now, I mentioned earlier that the fair value if it's known for public company versus private company, that that cannot, doesn't have to be 100% correct for public companies. Usually it's known for private company. It could be known as well, but anyhow, you will be given whether the fair value is known or not. So the fair value is known and there's a non-qualified stock option. On April 3rd, year one, when the fair value of the stock was 15, John exercised. So immediately the stock price jumped a lot. It just, this is a fake example, but the point is to kind of make the point. And on May 10th, John, the stock kept rising. John sold the shares and this sounds like the tech industry and the dotcom industry in year 99, 2000. The stocks were moving very fast. So what are the tax consequences here? What's the amount and type of income if any John should report on the grand date? The grand date was March 15, year one. They granted them the stock. We know the fair value is $2 for the $2 per option. We have 500 options. There's a $1,000 tax. So on the grand date, there's a $1,000 should report ordinary income of $1,000. And obviously, if they report ordinary income, they have to pay taxes on that. Now, determine the adjusted basis of the stock held by John as of April 3rd. On April 3rd, when the stock price was 15, what did John do? Exercise. And to exercise, you have to pay $10 per share. Well, $10 times 500 is $5,000. And John already included $1,000 of ordinary of ordinary income. Therefore, the basis for his stock for the 500 shares is $6,000. That's the basis. What is the amount and type of income that John would report when he sells the stock? He sells the stock for $18. Well, when he sells it for $18, his basis are how much for the stock? Well, his basis, remember, he sold the shares adjusted, when he sold the shares here at an adjusted basis of six. So we'll take 500 shares times 18. John would receive $9,000 in total. The adjusted basis is six. Therefore, there's a capital gain that John is responsible for for 3,000. So this is John's consequences. What are the employer consequences? Well, remember, the employer can deduct the expense in the year that it was granted. In other words, when John recognized ordinary income of $1,000, the employer can report an ordinary expense. The employer receives a deduction at the time John reported ordinary income, which is the grand date. Because on the grand date, they gave them 500 options. Each one is worth $2. Well, the company would recognize $1,000 of expense. They would reduce their taxable expense. So this was a non-qualified stock options with a known value. What happened if we are dealing with a non-qualified stock option without a readily determinable value? Well, under those circumstances, when we don't have a readily determinable value, the option are taxed when exercised. Remember, John exercised them when they were 15. This is when the tax consequences are kicked. This is when it takes place. On the exercise date, the employee recognized an ordinary income for the difference between the stock fair value and its exercise price. There's an ordinary income there. Ordinary income equal to the fair value of the stock minus the exercise price. The basis of the stock for the employee equal to the fair value on the exercise date. At this point, your basis equal to the fair value on the exercise date. So basis here equal to the fair value of the exercise date. Now, the future sale result either in a capital gain or a capital loss. Now, if the option lapse, the employee can deduct a capital loss that equal to the amount that they paid for the options. If the option lapse means the option was never exercised because it was out of the money. It's important to know that the holding period for the stock, for all non-qualified stock options, start at the exercise date. Remember, the holding period is important whether to determine that's a capital gain or a long-term capital gain or short-term capital gain because it makes a difference. Now, as for the employer, they do not receive a deduction on the grand date under the when there's no determinable value. Instead, they are allowed a deduction in the same year the employee report taxable income as a result of exercising the stock options. The amount of the employer's deduction is the same as the amount of the employee taxable income. So, whatever taxable income is John's subject to, the company can deduct. Let's take a look at this example. Number of shares to be purchased is 500 shares. The exercise price is $10. Now, we are not told we don't know the fair value of the options. You remember in the prior example, we said each option is worth $2. We are not told anything. On April 1st, year one, when the fair value is 15, John exercises option. Now, and on May 10th, when the price was 18, he sold his options. What is the amount and type of income if any John would report on the grand date? Well, on the grand date, remember, we are dealing with an option with no readily determinable value. They should not report any income on that date. Versus in the prior example, remember, they reported $1,000 because we assumed $2 value, which we don't have this information here. What is the amount of and type of income that John would report on the exercise date? Well, on the exercise date, John would report an ordinary income for the difference between the stock fair value and its exercise price. Well, there's $5 difference between those two. The strike price is the exercise price is 10 and we exercised at 15. There's $5 times 500 equal to 2500. And again, what we said, this will be considered ordinary income. On April 1st, what is the adjusted basis of the stock for April 1st? For April 1st, the adjusted basis equal to the fair market value of 500 shares times 15, which is 7,500. What type of income that John would report when he sells the stock? Well, should report a capital gain of 1500, which is the difference between 9,000, which is the how much he sold it for and the basis. This will be a capital gain. Is John's employer allowed to receive any deduction for tax purposes? If so, when and how much? Well, remember, yes, the employer receives a deduction. At the time, John reported ordinary income, which is the exercise date. And the amount of the deduction would be 2,500, which is the amount of ordinary income that John reported. What should you do now? Go to Farhat Lectures, look at additional resources. In the next session, we would look at the qualified stock options. We'll explain what they are and look at the different type of qualified options. Good luck, study hard, and of course, stay safe.