Hello, We are a private company. One of our employees has exercised his stock options by a promissory note. How should this transaction be journalized in our accounting system? Once he makes a repayment, how is that being recorded?

It's an employee loan. Repayment is just that; repayment of a loan. I typically discourage companies from allowing option exercises by means of a promissory note. Promissory notes can provide employees a means of exercising options and starting their capital gains holding periods without coming up with cash.

However, the promissory notes must be substantially full recourse to start the capital gains holding period, which creates a real obligation for the employee even if the stock eventually becomes worthless. A bankruptcy trustee might attempt to collect on a full recourse note in the event the company goes bankrupt.

Full recourse means that the note is a general obligation of the employee, as opposed to recourse being limited to the stock purchased in the event of default. If the note is repaid or forgiven in the future and there is a difference between the purchase price and fair market value at that time, then the employee may have a taxable event.

In addition, if the note is forgiven, it will create debt forgiveness income to the employee. The accounting for the exercise of the option, the issuance of stock, and the Promissory note is pretty straight forward.

However, for GAAP reporting, the Promissory note may end up being a contra equity account until paid. That is there has been no "paid-in" capital until the note is paid. Personally, I'd discuss this with both my audit partner and tax partner there are a lot of land mines here that could surprise everyone if not done correctly.

If the gamble goes bad, bad things happen. I strongly suggest looking into what happens when you forgive an employee loan.

Should a company allow option exercises with promissory notes?

There are flavors of outcomes; the worst flavors are particularly bad unreported deferred-comp penalties, etc. The IRS has taken action relative to past abuses, and you don't want to be caught in the dragnet.

Some light reading for you: In addition to interest collected, consider principal payments as well, at least nominal.

What are the tax consequences when purchasing shares with a promissory note? | FS Incubators Accelerators San Francisco Silicon Valley Bay Area China

As you know, collecting monies from departing employees can be challenging in certain states. I just went through this issue with my company and will re-iterated some of the issues mention above:.

It must be a recourse loan; otherwise, you lose any tax benefit of exercising those options.

Please note that the Accountant 's and Attorney's will differ on what it means by "recourse". In that case, that Accountant's will not want you to show the options as being exercised on the books although from a tax perspective it still may qualify for capital gains.

Don't infer or imply the loans may be forgiven.

Hughes Optioneering

In our case the loans were paid but the employees were given a bonus later on. You can amend the notes to extend them, but only onetime; otherwise, it may not pass IRS scrutiny. Browse our extensive library of free white papers focused on the latest financial, technology and business issues. Sign In Sign Up. Sign Up Sign In. Blogs White Papers Resources. Exercise Stock Option with Promissory Note.

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