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As a student of equity-based compensation, I find studying some of the similarities and differences of different techniques to be interesting.

For example, here is a comparison of some features of Employee Stock Purchase Plans (ESPPs) to Incentive Stock Options (ISOs).

In order to meet the holding period requirements for both ESPPs and ISOs, you must hold the stock for more than two years after grant of the option and more than one year after exercise.

The difference between the fair market value of the stock at exercise and the option price is a tax preference in computing the alternative minimum tax for ISOs. There is no AMT preference for ESPPs.

For ISOs, if the price of the stock declines after exercise of the option and it is sold before the holding period requirements are met, the ordinary income is limited to the actual gain. (For example, Sandy exercised Pear Company ISO in January, 1999. The fair market value at exercise is $100 per share, and the option price is $50 per share. She sells the shares on September 1, 1999 for $75 per share. Sandy will report ordinary income of $25 per share, and no AMT tax preference for 1999.)

When ESPP shares are sold before the holding period requirements are met, the taxpayer reports ordinary income for the excess of the fair market value at exercise over the option price and a capital loss for the excess of the fair market value at exercise over the sales price. Effectively, this can convert other capital gains to ordinary income, or can limit the loss offset to $3,000. (Use the same facts as the ISO example, disregarding the 85% rule for the moment. Sandy would report ordinary income of $50 per share and a short-term capital loss of $25 per share. If Sandy has other long-term capital gains, they would be reduced by the short-term loss, effectively converted to ordinary income. If Sandy has more than $3,000 in net capital losses, the excess will be disallowed as a current deduction and carried over to the next tax year. In that case, the ordinary income would not be offset by the capital loss in the year of sale.)

When the holding period requirements are met, any gain on the sale of ISO shares is long-term capital gain. For ESPP shares, ordinary income is still reported at the sale of the shares or the death of the employee for the lesser of (1) the excess of the fair market value of the share at the time of such disposition or death over the amount paid for the share under the option, or (2) the excess of the fair market value of the share at the time the option was granted over the option price. (For example, Sandy purchased Pear Company Stock through its ESPP program in 1995. She paid $85 per share, and the fair market value at grant was $100 per share. She sells the stock on September 1, 1999 for $90 per share. Sandy must report ordinary income of $5 per share, and has a capital gain of zero.)

This comparison is not all-inclusive, but it does highlight the differences between these two programs and particularly how employee stock purchase plans work.

Check out our book, Employee Stock Options, and the Corrections and Additions to it.

For more information about incentive stock options, request our special report, Incentive Stock Options - Executive Tax and Financial Planning Strategies

For answers to our readers' questions and to learn about new tax developments relating to employee stock options, subscribe to our newsletter, Michael Gray, CPA's Option Alert by filling out the form below.

IRS Circular 230 Disclosure: As required by U.S. Treasury Regulations, you are hereby advised that any written tax advice contained in this website was not written or intended to be used (and cannot be used) by any taxpayer for the purpose of avoiding penalties that may be imposed under the U.S. Internal Revenue Code.