Generally, a stock option is treated as exercised at the time the grantee, usually an employee of the grantor/employer, pays the strike price and takes possession of the stock, whether actually or constructively. Sometimes when an employee cannot afford to pay the strike price, the employer will assist the employee by granting him or her a loan to cover the cost. Normally, this is not a problem, but when the loan is a "non-recourse loan" it can have unintended tax consequences.
Under a non-recourse loan, the employer's only collateral is the underlying shares subject to the stock option. This means that if the employee defaults on the loan, the employer can only take back the shares but cannot go after the employee for anything beyond the shares. This is significant because it means if the stock value drops below the loan value, the employee would presumably purposely default on the loan since there would be no incentive to pay off a loan only to receive shares of a lesser value and the employer would be entitled only to the stock.
The employee is, in essence, in a position no different than before he or she was granted the loan. The loan essentially becomes the strike price and the employee can walk away if it's not worth it to pay off the loan. Because of this, for tax reasons, the non-recourse loan promissory note is treated as a new option grant which is treated as "exercised" when paid.
This has very important tax consequences. For stock options that are incentive stock options, or "ISOs," under Internal Revenue Code Section 422, the holding period to qualify for long-term capital gains doesn't start when the options are purchased with the non-recourse loan, but, rather, when the loan is paid. For non-qualified stock options—i.e., stock options that don't qualify as ISOs—in addition to capital gains issues, the grantee doesn't experience a taxable event when the options are purchased with the non-recourse loan, but, rather, when the loan is paid. There may also be negative consequences under Code Section 409A, which puts restrictions, and potential penalties, on options granted with a strike price below fair market value.
It can also be tricky to determine at what point the non-recourse loan is considered paid for purposes of determining whether the new "options" have been exercised. Payment is determined based on the specific facts and circumstances. An employer who has or plans to assist employees in exercising stock options by granting them non-recourse loans should consult an attorney or tax professional to help make that determination.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
