Here's Your Stock. Here's the Catch...

However, the prime mover in the picture is a regulatory change—specifically, the introduction of Financial Accounting Standard Number 123R.

Prior to 2005, companies could choose to award stock options to employees and take no expense on their income statements, explains attorney Debra Linder with the Fredrikson & Byron, P.A., law firm in Minneapolis. This made options a very attractive form of compensation from an accounting standpoint. Financial Accounting Standard 123R, phased in during 2005 and 2006 by the U.S. Securities and Exchange Commission, requires companies to calculate and disclose the value of stock options as an expense. The value usually is about one-third of the stock’s trading price at the time the option is granted.

That simple but significant change, experts say, undercuts the appeal of options in comparison with restricted stock plans, which always had to be taken as an expense. And restricted stock offers distinct advantages when it comes to producing and rewarding the kinds of behavior long-term incentives are supposed to encourage. So while options are still part of the mix in executive-compensation packages, their relative weight in those packages is diminishing.

What’s the Difference?

Practically any statement about the rules and tax consequences pertaining to different types of stock-based compensation is subject to numerous caveats. That said, here are a few basics.

As defined by Salary.com, stock options give someone the right, but not the obligation, to purchase a predetermined number of shares in the company at a fixed price within a certain period of time. There are two basic types. With incentive stock options, available only to a company’s employees, income is reported only when the stock is sold, not when the option is received or exercised (purchased by an employee), and may be taxed at lower capital-gains rates rather than as regular income. Nonqualified stock options may also be granted to nonemployees (board members or consultants, for instance). Nonqualified stock option income must be reported upon exercising the option, and the gain—the difference between the sale price and the purchase price—is treated as ordinary income for tax purposes.

Regardless of an option’s type, the purpose is to give employees a stake in the effort to increase shareholder value. Unless stock price rises over time, options are worthless. From the perspective of the board of director’s, “the premise is that we’ll share with an employee the fruits of our success as a company,” says Matthew Turner, a Chicago-based specialist in executive compensation for Mercer Human Resource Consulting, which has offices in Minneapolis.