By Karen E. Klein Q: There is a great deal of controversy regarding the valuation of stock options, yet companies routinely deduct them for tax purposes. How do companies value stock options for tax purposes? -- F.B., Milwaukee
A: The tax rules related to stock options are very complex, and if you are preparing your personal or business IRS filings, you should definitely consult your accountant and/or attorney for their approval before you submit any paperwork.
Generally, however, employers get compensation deductions when their employees actually exercise "nonqualified stock options" (as opposed to "incentive stock options," another type of option that has its own set of complicated rules and does not involve a tax deduction for the employer).
Nonqualified stock options are taxed to the employee as income (usually on their W-2 form) at the time they are granted, but only if the options have a "readily ascertainable" fair market value -- which typically means that they are publicly traded, says CPA Gregg Wind. If the underlying stock is publicly traded on an established securities market (NYSE, Nasdaq, etc.), the value on a particular day is determined to be the average between the high and low selling prices on that date, he explains. However, typically the option itself is not listed on the exchange and is nontransferable, so it's more common for the taxation to occur when the stock option is exercised, even if the underlying stock is publicly traded.
DIFFERENT METHODS. If the stock options are granted by a closely held private company, and their market value is unknown, then the taxable income will always accrue to the employee at the time the options are exercised. This is also when the employer gets a corresponding compensation deduction.
How is the market value determined when the options are issued by a private company? The IRS uses a formula for tax purposes, says CPA/CFP Stephen Kunkel, director of taxes for CBIZ. "The options are valued by subtracting the 'strike price' [the amount for which the underlying shares can be purchased] from the 'fair
market value' of the stock at the time of exercise," he says. "The IRS defines fair market value as the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts."
The number that results from the fair market value minus the strike price is called the "bargain element," and it is this number which is used for tax purposes.
DISCOUNTED WORTH. Closely held private companies are difficult to value, and so are their stock options. This type of company must be valued by a qualified business appraiser who first must determine the value of the entire company as a whole. Says Kunkel: "This value would be divided by the number of shares outstanding to arrive at a per-share valuation. Since the privately held stock is not tradable on an established exchange, it is also reduced to reflect a significant discount for lack of marketability and minority interest. The discount should reflect the economic discount that an investor would require to invest in such an illiquid security."
There are also restrictions on nonqualified options that vest with the passage of time and affect tax valuations, but that's probably getting into an even more complex area, one beyond the scope of your question. Have a question about running your business? Ask our small-business experts. Send us an e-mail at email@example.com, or write to Smart Answers, BW Online, 46th Floor, 1221 Avenue of the Americas, New York, NY 10020. Please include your real name and phone number in case we need more information; only your initials and city will be printed. Because of the volume of mail, we won't be able to respond to all questions personally.