Tax Treatment of Employee Stock Option -- Fair? Unfair?

[igorlord]

Inspired by: http://angerona.livejournal.com/665475.html

What are the employee stock options? Are they a mere "promise of a bonus" or a "valueable investment position"? I know the IRS's answer. But I am after reasons/logic/fairness here.

First, let's compare Employee Stock Options to ordinary Bonuses, which we all probably agree should be taxed as Ordinary Income at the time they are given out.

Bonuses are uncertain but are sometimes given based on the good perfornace of the company. Options are similar -- their payoff is uncertain but is based on the good perfornace of the company. So, we could equate granting a stock option with a promise to give a bonus in the future based on how much better the company will be doing in the future.

So we seem to have only three logical outcomes:

1. Tax a "promise of the bonus" as Ordinary Income when the promise is given (and we'd need to assign a "value" to such a "promise"); then, when and if the bonus is received, tax the actual bonus as cap gains.
2. Tax a "promise of the bonus" as Ordinary Income when and if the promise is received (and we'd need to assign a "value" to such a "promise"); also, at the same time, tax the actual bonus as cap gains.
3. Tax the actual bonus when it is received as Ordinary Income.

The problem here is that this notion of an Option as a mere "promise of a bonus" clashes with the notion of a regular investment.

If instead of getting this Option from the company for free, I were to get an actual cash bonus for which I'd buy a 10 year Call Option on the open market, I would be receiving the same "promise of a bonus if the company will be doing better". Then, I'd be taxed according to the #1 above instead of #3. But what changed? (Yes, purists will tell me that market Call options are more valuable, since there are fewer restriction on them -- like being valid only till you quit the company and inability to resell it, but this seems to be a quantititive and not qualitative difference in the values.)

So is the Option a mere "promise of a bonus" or a "valuable investment position"? That seems like a tough question!

I'd welcome more thoughts about it! (Just do not quote me IRS regulations as an "argument".)