CPM Executive Compensation & Equity Plans 1 — Questions and Answers
Question 1: Which type of stock option allows employees to potentially avoid ordinary income tax at exercise if statutory holding requirements are met?
- Non-qualified stock options (NQSOs)
- Incentive stock options (ISOs) (Correct answer)
- Stock appreciation rights (SARs)
- Restricted stock units (RSUs)
Correct answer: Incentive stock options (ISOs)
Incentive stock options (ISOs) allow employees to defer income recognition until sale and qualify for capital gains treatment if both holding period requirements are met.
Question 2: When an employee exercises a non-qualified stock option (NQSO), the spread between the exercise price and fair market value is treated as:
- Ordinary income subject to federal income tax and FICA withholding (Correct answer)
- Long-term capital gain income
- A tax-exempt fringe benefit
- Deferred compensation under Section 409A
Correct answer: Ordinary income subject to federal income tax and FICA withholding
The spread on NQSO exercise is ordinary compensation income subject to federal income tax withholding and FICA taxes in the year of exercise.
Question 3: Restricted Stock Units (RSUs) are generally recognized as taxable income to the employee at:
- Grant date
- Sale date
- Vesting date (Correct answer)
- Board approval date
Correct answer: Vesting date
RSUs are taxable as ordinary compensation income at the vesting date, when restrictions lapse and the employee has an unrestricted right to the shares.
Question 4: For Incentive Stock Options (ISOs), which item is a preference item for Alternative Minimum Tax (AMT) purposes in the year of exercise?
- The grant date fair market value of the options
- The vesting date value of the shares
- The final sale price minus the exercise price
- The spread between the exercise price and FMV at exercise (Correct answer)
Correct answer: The spread between the exercise price and FMV at exercise
The spread between the exercise price and FMV at exercise is an AMT preference item for ISOs, potentially triggering AMT even though no regular income tax is owed at exercise.
Question 5: Under IRC Section 83(b), an employee who receives restricted stock (not RSUs) may elect to:
- Recognize income at the grant date based on current FMV rather than waiting until vesting (Correct answer)
- Defer income recognition until the stock is sold
- Convert all future appreciation into tax-free income
- Exclude the stock value from gross income entirely
Correct answer: Recognize income at the grant date based on current FMV rather than waiting until vesting
A Section 83(b) election accelerates income recognition to the grant date (when FMV may be lower), potentially converting future appreciation to capital gain treatment.
Question 6: Stock Appreciation Rights (SARs) that are settled in cash are classified for accounting purposes as:
- Equity awards with a fixed expense recognized at grant
- Liability awards with compensation expense marked to market each period (Correct answer)
- Capital gains instruments for the recipient
- Deferred compensation exempt from payroll taxes
Correct answer: Liability awards with compensation expense marked to market each period
Cash-settled SARs are liability awards because the employer's obligation fluctuates with the stock price and must be remeasured at fair value each reporting period.
Question 7: Which IRS form must employers file to report each employee exercise of an Incentive Stock Option (ISO)?
- Form W-2
- Form 1099-B
- Form 3921 (Correct answer)
- Form 3922
Correct answer: Form 3921
Employers must file Form 3921 for each ISO exercise, reporting the grant date, exercise date, exercise price, and fair market value at exercise.
CPM Executive Compensation & Equity Plans 1
Which type of stock option allows employees to potentially avoid ordinary income tax at exercise if statutory holding requirements are met?