Offering employee stock options is the prevailing trend in the corporate world today with over 90% of Fortune 1000 corporations giving their employees stock options. There are three kinds of employee stock options: the Incentive Stock Option (ISO), the Employee Stock Purchase Plan (ESPP) and the Non-qualified Stock Option (NQSO). For purposes of this discussion, I will introduce you to the concept of ESPP and the requirements that make an employee stock option qualified to be an ESPP.
ESPP is a kind of employee stock option which offers tax benefits to the employees if the employee stock option meets the restrictions and requirements set by Section 423 of the Internal Revenue Code. Like any other employee stock option, ESPP is offered by the corporation wherein the employee has a choice to buy a certain number of stocks, for a certain price called strike price, and within a certain period. ESPP are often offered by companies to their rank and file employees rather than to executive or managerial positions. In order for an employee stock option to be ESPP, it must meet the following requirements as enumerated in Section 423 of the Internal Revenue Code:
1. The ESPP must be offered only to employees of the corporation or employees of the corporation’s subsidiary or parent corporation;
2. The employee must not own more than 5% of all of the corporation’s stocks or 5% of the voting power of the shareholders;
3. 12 months before the adoption of the ESPP or 12 month after, the shareholders are required to approve the grant of ESPP;
4. The underlying stock that is involved in the ESPP must be capital stock of the corporation regardless of it being voting or nonvoting stock, common or preferred, as well as stocks of original issue or treasury stocks;
5. For an employee stock option to qualify as an ESPP, all employees of the corporation must be integrated in the ESPP. However, those employees that are either with already high compensations, those that have been employed for only less than 2 years, those that work for only 20 hours a week, and those that work for only 5 months a year can be excluded from the ESPP;
6. All provisions in the ESPP, especially those pertaining to the strike price and the option payment are required to be similar with all employees subject to the following exceptions:
a. The ESPP can specify how many options can be used under the ESPP
b. Restriction on the ESPP may be specified that limits the number of options relative to the employee’s total compensation or the base rate of compensation;
7. The ESPP must specify that no employee can buy more than $25,000 worth of the company’s stocks, computed at the time of grant, per calendar year that the option is subsisting;
8. For the employee stock option to qualify as ESPP, the option price or strike price must not be less than 85% of the stock’s price at the time of grant or less than 85% of the stock’s price at the time that the option was exercised;
9. The employee stock option whose exercise price is 85% or more of the current share price may only be exercised up to a maximum of 5 years whereas if the option price was derived in any other manner, the employee stock option must be exercised within 27 months;
10. An ESPP is non-transferable except by law and by will and that only the employee can exercise his ESPP while he is still alive.