"Knowing Your Options - The Tax Ramifications of Stock Options"

By Peter Jason Riley, CPA

There are in essence 2 types of stock options: Incentive Stock Options (ISO) and Non-qualified Stock Options. The first step is to decide which type you have (sometimes an employee can have both from the same company). Once you know which type you possess you can figure out the tax effects and begin the planning process.

So how do you tell which type of options you have? First, only an employee can receive ISOs so if you are not an employee of the issuing company your options have to be non-qualified stock options. If you are an employee of the company in question you must look to the option documentation provided by the plan administrator. As IRS regulations govern stock options you can imagine that the rules are fairly complex, but in essence the company has to tell you it is an ISO in the option document. If they do not state the options are ISOs then it is most likely a non-qualified stock option. To qualify as an ISO the option plan must meet certain requirements; it must be approved by the company shareholders, the option price must be market value on date of issue, the option cannot extend out more then 10 years, there is a $100K annual limit, and there are special restrictions for shareholders that own more then 10% of the company. Non-qualified stock options are by far the most popular type as they have less restrictions then ISOs.

The heart of the tax issue for both types of options concerns the timing of the exercise and the play between ordinary (W-2/1099) income and potential long-term capital gains treatment. In the case of ISOs we have to deal with the great IRS stealth tax, the alternative minimum tax (AMT). As options are rarely taxable when received the first taxable event centers on the "bargain element," in short the difference between the option price (strike price) and the market value on the date of exercise.

We are going to use the same example throughout our explanation. Our employee is Big Al and he has received options from his employer Toad Corporation. His basic tax return is found in 1040 example one. The amount he is paying to exercise his options is $10 and the market value of Toad Corporation is $100 when Al exercises them. If the option price is $10 for a share of stock in Toad Corporation and on the date of exercise it has a market value of $100 the recipient has in essence received something worth $100 by only paying $10. In simple terms this will cause a taxable event on some level for the $90. This is the "bargain element."

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Non-qualified stock options

The non-qualified stock option is an option or right to buy a companies stock at a specified price in the future. You do not report income at the time you receive the option even though the option may indeed have a market value. The taxable event comes at the time you exercise the option. When the option is exercised the recipient will report compensation income for the bargain element.

In our 1040 example two our employee Big Al exercised 1000 shares of Toad Corp. stock that was worth $100 a share, he paid only $10 per share. In other words he received something worth $100k by only paying $10,000. If Big Al is an employee the $90K will be added to his normal $50K W-2 and give him a total W-2 income of $140K. If he is not an employee he will probably be issued a 1099 and it will be reported on line 21 of his 1040. As Big Al plans the exercising of his non-qualified stock options he has to decide on either a cash-less "same-day" exercise or to exercise and hold to try and get some of the future appreciation as a long-term capital gain (held for more then 1 year). If Big Al does a "same-day exercise" the broker will sell his shares and use the proceeds to purchase the options, pay the taxes and send Big Al his net proceeds. The stock transaction will still be reported on schedule D but there will be no gain as the gain is reflected in the W-2. It will look something like this:

What if Big Al decides Toad Corp is a good long term investment and decides to exercise and hold? He will have to come up with the $10K to purchase the options the company and is also required to remit the proper withholding taxes from him (this does not seem to be common practice). In other words his "ticket price for exercising and holding will be $43,394 ($10K + $25,200 + $2,929 + $5,265). His basis for the stock will be the $100, the $10 that he paid and the $90 that was declared on his W-2. The holding period for long-term capital gains starts generally when the stock is exercised. While the cash outlay of $43,394 sounds like a lot, Big Al has taken possession of stock worth $100K paying only $43,394. On the other hand in the cash-less "same day" exercise he received basically $56,606 cash over and above his regular paycheck, risk free.

Tax Tip ~ if you plan on exercising and holding your non-qualified stock option you want to do it when the market value is LOW and you will decrease the ordinary income and tax payout. If you plan on doing a cash-less exercise you want the value to be high to maximize the net cash received.

If company requires you to earn the shares after you exercise them then the stock has a "vesting component." This changes the timing of the taxable event from the exercise date until the date the stock is fully vested, more on that later, more on that later.

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Incentive Stock Options

The ISO is an option or right to buy a companies stock at a specified price in the future. You do not report income at the time you receive the option even though the option may indeed have a market value. There is a POTENTIAL taxable event that comes at the time you exercise the option. When the option is exercised the recipient will report alternative minimum taxable income for the bargain element.

There is little question that thorniest tax complication concerning ISOs centers around the alternative minimum tax (AMT). The AMT is a section of the tax code that was originally put into place to capture taxpayers who were utilizing the code to such extreme advantage that they were driving their tax liability to unreasonably low amounts in regards to their overall income. It is not a calculation that tax professionals typically see very often as a general rule except in regards to ISOs. In the case of ISOs it looms very large indeed, and must be calculated in each and every case to determine its effect. Like the non-qualified stock option there is a potential taxable event in the bargain element on the exercise of the ISO, but in the case of the ISO it is a potential AMT taxable event NOT a regular ordinary income event. In other words there is no regular income tax event on the exercising of ISOs. Consequently there is no withholdings, FICA taxes, etc. The employee simply comes up with the cash for the purchase and takes possession of the stock.

Why do I keep reiterating the fact that the AMT is a "potential" taxable event? That is because the AMT does not kick in on the first dollar of AMT income. The AMT is a tax assessed on a group of adjustments such as; depreciation, schedule A itemized deductions, etc. That is why it must be calculated on each individual return to see exactly when it kicks in. I look for what I call the "sweet spot," that exact point when the ISO income causes an AMT liability.

Back to our friend Big Al who exercised his 1000 shares of Toad Corporation stock on a day when the value was $100 and his option price was $10. Like the non-qualified stock option Big Al again has basically 2 options when he exercises his ISOs, the cash less "same day" exercise (1040 example three) and the exercise and hold strategy. The stock transaction will still be reported on schedule D but there will be no gain as the gain is reflected in the W-2. If he chooses the so-called cashless option it will look like this:

If Big Al decides to exercise and hold (1040 example four) he will incur no regular income tax. Unlike the non-qualified stock option there is no regular income tax on exercising the option. What there is instead is the AMT tax. The bargain on the date of exercise is subject to AMT. In Al's case he will incur what is called a $90K AMT adjustment if he were to exercise his 1000 shares. The $90K is the difference between the $10K purchase price (1000 * $10) and the $100K market value ($1000 * $100). The AMT is a tax that has to be calculated on a tax-return by tax-return basis, there is no rule of thumb for the AMT. In Al's case he will incur an AMT in the amount of $18,594.

Tax Tip ~ There is generally a point where the exercise of ISOs does NOT cause an AMT liability. That means there can be years when you can exercise ISOs and it will cost nothing but the option purchase price. It is imperative to find out what the "sweet spot" is on your return. The "sweet spot" on Big Al's 1040 return for 1998 is about $18K. In other words Big Al could exercise ISOs with a bargain element of $18K and NOT incur any new tax liability at all. Keep in mind that this point will change year by year.

The next question here is what the result will be when the stock is subsequently sold 12 months later. As you can see in regards to the ISO the regular income tax and the AMT follow a duel track. The AMT is a bit like the bizarro world in the old Jerry Seinfeld show, it exists in the shadow of the regular income tax and causes the taxpayer to do a tandem calculation in the year of exercise and every subsequent year that there is any activity on the stock in question. As we see in example 1 the effect of Als $90K of AMT income causes his tax to go from $4,346 to $22,940, a cost of $18,594. The AMT is calculated on the date of exercise regardless of what happens to the value of the stock during the balance of the year, BUT it is only assessed if you are holding the shares at year-end. Our next big question is what happens in the subsequent year of sale?

In our 1040 example five we will have Big Al hold the 1000 shares of Toad Corp. for exactly 1 year and a day, then sell them for the same $100 a share they were worth on the day of exercise (in other words the shares of Toad Corp have not gone up in value). In 1999 Big Al has a long-term capital gain of $90K ($100K selling price less the $10K purchase price). We also see that the AMT tax paid in 1998 REVERSES itself and becomes a credit of $18,594. Here is what Al saved by doing his exercise and hold maneuver:

As you can see the exercise and hold maneuver can yield substantial savings, even when the stock stays at a steady value. This is because the AMT in the best-case scenario is more of a pre-payment of taxes rather then an additional tax. Even if the stock loses value (within reason) Al will still come out ahead.

Tax Tip ~ The perfect time to exercise and hold your ISO stocks is the first quarter of the year. This is because you start the clock ticking on the 12-month holding period so that you will be able to sell shares at the favorable long-term capital gains rate to pay the AMT tax BEFORE April 15th. The second reason is that the AMT is not actually assessed unless you are still holding the shares on 12/31. That means that if the stock loses value before year-end you can sell the shares and lower or eliminate altogether the AMT.

The worst-case scenario is to have Big Al's shares of Toad Corp decline sharply by year-end. If Al does not take the opportunity to sell some or all the shares before 12/31 he will be left with the AMT bill of $18,594 and perhaps be holding stock that is not even worth that amount. He will end up with an AMT capital loss credit that he will be unlikely to ever be able to use. In this case the AMT is indeed an additional tax bill.

Another issue specific to ISOs is the one of early dispositions. To avoid early disposition you must hold the stock the later of; 1 year after exercising the ISO OR 2 years after the date granted. If you sell the stock within this period it is termed a disqualifying disposition and will generally be taxed as ordinary income. That is why the cash-less exercise looks similar for the non-qualified option as it does for the ISO. The IRS does not require withholding or FICA taxes on the disqualifying disposition, but federal and state income will be due at the filing date (1040 example three).

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The Vesting Option Ð Non-Qualified Stock Options and ISOs

If company requires you to earn the shares after you exercise them then the stock has a "vesting component." This changes the timing of the taxable event from the exercise date until the date the stock is fully vested. In our example if Big Al exercises his stock when it is worth $100 but it does not vest for 12 months the taxable event will not be on the date of exercise but on the date of vesting. So if the stock is worth only $50 in 12 months his taxable income for the non-qualified stock option will be only the $50 market value. By the same token if the shares are worth $150 he will have $150 in taxable ordinary compensation income. Big Al can alter the taxation date by filing a "Section 83b Election." The 83b election is an election that must be filed within 30 days after you exercise the option that elects to have the stock taxed at its value on exercise date even though it is not fully vested. This election also works for ISOs in regards to the AMT.

Tax Tip ~ Keep in mind this is a NON-REVERSIBLE election, once you do it you are stuck regardless of what happens to the stock value. This generally would only be considered when the stock on date of exercise is very low.

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Summary

Finally keep in mind I have used a "bright line" example here to clearly highlight the basic issues involved with stock options. This is not meant to be the whole story and is also not meant as a model on what you should do with your stock options. These are very complex matters and need to be analyzed on a case-by-case basis. It is clearly not a job for amateurs as stock options can be a tax minefield. Be sure to consult a qualified tax advisor as well as a qualified financial planner as the issues surrounding stock options are a matter of both investment planning and tax planning.

For information on the Internet on stock options:

• www.fairmark.com - home of our favorite book on stock options "Consider Your Options" by Kaye Thompson
• www.mystockoptions.com - has a lot of good information and some good calculators