Myth: You must grant stock options with a fair market value exercise price.
Truth: A nonstatutory stock option can be granted with a discount exercise price if:
- The stock option is fixed-exercise; or
- The stock option meets the independent contractor exception.
Most stock option plans don’t allow for discount stock options so you likely would need to use a form of non-plan stock option agreement.
Fixed-Exercise Stock Options
A stock option is fixed-exercise if it is exercisable only on the earlier of one or more of the following: death, disability, a separate from service, a change in control, or a fixed date (which can be as broad as a calendar year, but which cannot span calendar years).
Frequently such options are exercisable only on a change in control. What this means in practice is that such option will never be exercised, but will instead be cashed out if an exit occurs during the term of the option. The cash-out results in ordinary income treatment to the optionee. So, in one sense, this type of option is really just a fancy bonus award.
The Independent Contractor Exception
A stock option meets the “independent contractor” exception[1], as long as through each year in which it vests, the recipient:
- is not providing management services;
- is not an employee;
- is not related by blood or ownership to the issuer; and
- does not receive greater than 70% of its income from any one client.
How Low Can You Go
As a separate matter, folks worry that if you discount the exercise price too low, the Internal Revenue Service might try to recharacterize the award as a restricted stock grant, taxable on grant if it is vested or a tax code Section 83(b) election is filed, otherwise taxable as it vests.
Conservative practitioners will tell you not to discount below 25% of fair market value. So, for example, if the current fair market value of the stock is $1.00, do not set the exercise price below $0.25. This is based off of a Supreme Court case where such an option was respected. See Commissioner v. LoBue, 351 U.S. 243 (1956). However, based on additional case law, I think you can easily go down to 10%, or $0.10 in our example, without a problem. If on the other hand, the exercise price was $0.0001 and the stock was worth a $1.00, now I think you may have a restricted stock grant.
Mike Baker frequently advises with respect to discount stock options. He possesses a breadth and depth of experience in tax and employee benefits & compensation law that spans multiple decades. For additional information, please contact mike@mbakertaxlaw.com.
[1] See Treasury Regulation Section 1.409A-1(f)(2).