Also in this Issue:
-Stock Options: The Basics
-Gifts of Stock Options for Estate
Planning Purposes
-Tips and Traps for Options in
Real Estate Contracts
A BRIEF GUIDE TO STOCK OPTION TAXATION AND A FEW ILLUSTRATIONS
by Jeffrey B. Detwiler detwiler@ddrs.com
There are two basic types of compensatory stock options:
Nonqualified (or Nonstatutory) Stock Options ("NSOs"), and Incentive
Stock Options ("ISOs"). While the ISO is taxed under special
rules intended to provide "favorable" treatment to the optionee
by converting more of the appreciation in the stock represented by the
difference in fair market value of the stock and the option price for
the stock (the "Spread") into capital gain, the outcome is not
favorable under all circumstances. The general tax rules applicable to
NSOs and ISOs are summarized below.
Nonqualified Stock Option (NSO)
Incentive Stock Option (ISO)
-Eligibility: Any service provider may hold NSOs, including consultants,
independent contractors, suppliers, directors, or employers
-Employees only
-Grant Price: No limitation under tax rules--except that the price must
be high enough so that it represents a real option rather than a transfer
of the stock. Special accounting rules may apply to require a charge to
earnings for book purposes if the grant is less than 85% of fair market
value. Must be granted at no less than 100% of fair market value of stock
on the grant date; 110% for optionees who are 10% shareholders.
-Tax on Grant: None
TAX ON EXERCISE:
-Regular Income Tax
The Spread is taxable as ordinary compensation income, subject to ordinary
income tax at federal rates up to 39.6%, plus FICA, Medicare and state
income taxes through withholding (often requiring a sale of the shares
or a cash payment from the employee to the employer to provide withholding
funds). Total effective tax rate for a high income California resident
would be approximately 46.7% in federal, California and Medicare tax costs,
None
-Alternative Minimum Tax: None
-AMT potentially applies to the Spread at a federal rate of 28%. Application
depends on the amount of the Spread and other AMT "preference items,"
as well as the optionee's income level, with higher Spreads and income
levels likely to trigger AMT. AMT results in a credit which can be used
to offset taxes on future ordinary income, but the credit cannot offset
future long term capital gains from stock sales. (Optionee can eliminate
AMT by quick sale of shares--See Holding Period below.)
-Post-Exercise Sale of Shares. Because the exercise of an NSO triggers
taxation, the optionee receives a basis equal to fair market value on
the exercise date. This new basis is used to measure gain on subsequent
sales of stock.
Shares acquired through ISO exercise have a basis equal to the exercise
price, regardless of the fair market value of shares at the time of exercise.
Gain on sale includes pre-exercise appreciation.
-Holding Periods:The beginning point for determining whether the stock
has been held for the required long term capital gain holding period (more
than one year) begins on the exercise date. To qualify for long term capital
gain treatment, stock acquired through exercise of an ISO must not be
sold within one year after exercise or within two years after the grant
date. A "disqualifying disposition" subjects the ISO to taxation
almost identical to exercise of the NSO (including elimination of AMT)
except that withholding does not apply. If stock acquired with an ISO
is sold in a disqualifying disposition at less than the exercise price,
the lower sales price is used to calculate ordinary income taxes on the
transaction. (This can be a tremendous tax reduction opportunity in a
falling market.)
Examples The following examples are intended to illustrate some aspects of stock option taxation.
Example #1
An option for 10,000 shares of XYZ, Inc. common stock is granted on February 1, 2001 at an exercise price of $1.00 per share. The option is exercised on February 1, 2002 when the stock is valued at $2.00 per share and the 10,000 shares are sold on February 2, 2003 at $12.00 per share.
NSO Treatment
If the option is granted as an NSO, the optionee will have ordinary income tax on $10,000 of income (Spread of $1.00 x 10,000) at an effective rate of about 46.7% for tax of $4,670, a portion of which must be paid by arrangement with the employer at the time of exercise. At the time of sale of the 10,000 shares, the optionee would be taxable at long term capital gain rates (approximate effective rate of 28% federal and California) on $100,000 ($12 sale price, minus $2 basis x 10,000 shares) for a capital gain tax cost of $28,000 and a total tax cost of $32,670.
ISO Treatment
If the 10,000 share option is granted as an ISO, there is no regular tax on exercise. The $10,000 Spread is potentially subject to AMT, but would not likely result in AMT unless the optionee had other significant "preference items." Upon sale, since the optionee has met all ISO holding periods, the entire difference between the $12 per share sales price and the $1 per share exercise cost ($110,000) would be subject to tax as long term capital gain of approximately $30,800. In this situation, taxation of the ISO is clearly preferable, resulting in both deferral and lower overall tax costs.
Example #2
Assume the same facts in Example #1, but assume that exercise occurs when the stock is valued at $11 per share instead of $1 per share, and assume that the optionee is subject to AMT.
NSO Treatment
The exercise of the NSO would result in $100,000 of ordinary income ($10 Spread x 10,000 shares), which would result in approximately $46,700 in federal, state and employment taxes on exercise. The sale of the 10,000 shares one year and a day later would yield capital gain of $10,000 ($12/share sales price minus $11/share basis x 10,000), taxable at a rate of approximately 28% for a long term capital gain tax of $2,800 and an overall tax cost of $49,500.
ISO Treatment
The exercise would not be subject to regular tax, but would be subject to federal AMT at a 28% rate on the $100,000 Spread for a total AMT cost of $28,000. The sale of the shares one year and a day later would be subject to capital gain tax on $110,000 ($12/share sales price minus $1/share basis x 10,000 shares) at effective rates of approximately 28% for a capital gain tax of $30,800 and an overall tax of $58,800.
In this case, the AMT makes the ISO the more tax costly approach. One possibility would be to sell the 10,000 ISO shares two days earlier, thus creating a disqualifying disposition and eliminating the AMT, thus subjecting the entire $11 Spread to tax at ordinary income rates for a total tax cost of $51,370. While this approach reduces the overall tax cost, it is still more tax costly than the NSO.
In either case, the substantial tax cost upon exercise would likely necessitate an early sale of the stock to fund tax costs. This reality of option taxation is reflected in the fact that most companies which issue options report that over 75% of shares acquired through option exercises are sold immediately.
Example #3
Assume the same facts as in Example #2 except that the stock falls back to a value of $1.00 per share by February 2, 2003.
NSO Treatment
As in Example #1, the tax cost on exercise is $46,700. If sold one year and a day later at $1.00/share, the sale generates a $10 per share capital loss--which can be used only to offset future capital gains (except for $3,000 per year which may be used to offset ordinary income).
ISO Treatment
Sale after meeting the required holding periods at $1.00 per share would generate no capital gain, but the optionee would have incurred $28,000 of AMT on the transaction. Sale of the 10,000 shares BEFORE the holding period requirements are met would disqualify the ISO, eliminate the AMT, and subject the transaction to NSO tax on the Spread between the $1.00 exercise price and the $1.00 sale price-- meaning all taxes are eliminated.
The foregoing examples illustrate the need to plan carefully for exercise of stock options and disposition of shares acquired through option exercises.
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