Tax planning for incentive stock options

Weighing your options: tax planning for incentive stock options

Allison Rogers

This article provides an overview of the income tax and AMT implications of exercising ISOs, and holding or disposing of stock acquired on exercise.

Employee stock options are frequently part of the compensation packages corporations offer to employees. These options are either statutory (also “qualified”) or nonstatutory (also “nonqualified”). In very general terms, nonstatutory options trigger gross income to employees at either grantor exercise, and concomitantly produce deductions for employers.(1) Statutory options, by contrast, afford special tax benefits to employees; they generally do not trigger income, and consequently employers are denied offsetting deductions.(2) Nonstatutory options are more prevalent than statutory options probably because vesting is not limited by amount and because employers are allowed offsetting deductions. Recently, however, statutory options have become popular, especially among technology employers, many of whom have soaring stock values, but lack current earnings, and consequently are less concerned with deductions.

Statutory options include employee stock purchase plans and incentive stock options (ISOs), both of which allow employers to share stock appreciation with employees. Employee stock purchase plans, like qualified retirement plans, are restricted by nondiscrimination rules and usually defer the realization of appreciation until an employee’s retirement.(3) ISOs, however, are not restricted by the nondiscrimination rules and allow corporations to target employees who are most likely to influence stock value. Moreover, these employees may realize stock appreciation in relatively short periods of time (and, importantly, while they are still employed). With the explosion of stock value, however, many ISO holders will be subjected to a hefty alternative minimum tax.

Statutory options qualify as ISOs only if they comply with the requirements set forth in the Internal Revenue Code of 1986, as amended.(4) In general, an ]SO must be granted pursuant to a written plan that may not continue for more than 10 years. ISOs granted under the plan must be granted to employees, and lapse within 10 years of grant. The exercise price (strike price) must meet or exceed the fair market value (or 110 percent of the fair market value, if the optionee is a 10 percent shareholder) of the underlying stock at grant. Moreover, an option qualifies as an ISO only to the extent it annually vests the right to purchase no more than $100,000 of stock valued at grant. If an option vests more, it qualifies only with respect to the first $100,000 of stock vesting per annum, and is deemed nonstatutory with respect to additional shares, provided, however, that the plan allows for both statutory and nonstatutory options.

This $100,000 restriction limits only the value of stock vesting in a given year, not the value of stock an optionee may acquire. Thus, if an ISO qualifies with respect to vesting shares (and otherwise), an optionee generally may exercise with respect to vested or unvested shares, in whole or in part, at any time prior to lapse. An optionee must exercise, however, while employed by the grantor or within the statutorily prescribed extension periods. In addition, an ISO may not be transferred except by will (or pursuant to the laws of descent) or be exercised except by the optionee (or the optionee’s estate or guardian). Finally, upon exercise, the optionee must hold acquired stock for at least two years after grant and one year after exercise. If the optionee disposes of acquired stock, by sale or remission, prior to expiration of either holding period, the option is deemed nonstatutory with respect to those shares and is taxed accordingly.

Although this article focuses on the federal tax implications of exercising ISOs, and holding or disposing of the stock acquired on exercise, ISOs necessarily implicate career, investment, and securities law issues. For example, because an ISO generally must be exercised while an optionee is employed by the grantor, an optionee’s career mobility or job security may influence the timing of exercise. In addition, if an optionee is an “insider” pursuant to the securities laws, or acquires stock not subject to a registration statement, the optionee’s ability to dispose of stock may be limited by statute. Even if disposition is not limited statutorily, it may be limited contractually through a market standoff or the grantor’s right of first refusal. Finally, if an optionee’s stake in the grantor’s stock represents a majority of the optionee’s net worth, diversification issues may dominate tax strategies. Although this article highlights some nontax issues associated with ISOs, it does not address them in detail. Before counseling the holder of an ISO, tax advisors should consult other experts, such as financial planners and securities attorneys to assist in considering these nontax issues.

Income Tax Implications of an ISO

To the extent an option qualifies as an ISO, the optionee is not taxed at grant or exercise, except pursuant to the alternative minimum tax, discussed below. In general, on exercise of an ISO, an optionee acquires stock with a basis equal to the strike price, and any excess value is not currently taxed as income. When the optionee subsequently sells the stock, any gain usually is taxed as capital gain.

To illustrate, assume that (a) in 1998, an optionee is granted an ISO to purchase stock at $5 per share; (b) in 2000, the optionee exercises when the stock’s fair market value is $100; and (c) in 2005, the optionee sells the acquired stock when the fair market value is $145. To the extent the option qualifies as an ISO, the optionee is not taxed at grant (in 1998) or exercise (in 2000). At exercise, the optionee pays $5 per share strike price, and holds the acquired stock with a $5 basis. In 2005, the optionee sells the stock for $145, and pays tax on capital gains of $140 ($145 sale price — $5 basis).

If an option otherwise qualifies as an ISO, but the optionee disposes of acquired shares prior to expiration of both statutory holding periods (two years after grant and one year after exercise), the optionee is taxed, at the time of the disqualifying disposition, as if the option were nonstatutory. More specifically, to the extent the option is nonstatutory, the optionee is taxed on compensation income equal to the difference between the strike price and the fair market value at exercise. Thus, in the above example, if the optionee disposes of the acquired stock in 2000 at a fair market value of $115, the optionee would be taxed (in 2000) on $95 ($100 fair market value at exercise — $5 strike price) of compensation income and short term capital gain of $15 ($115 sale price — $100 fair market value at exercise). If an optionee recognizes compensation income on a disqualifying disposition, the employer may recognize a compensatory deduction of the same amount.

* Payment of Strike Price

Most option plans permit an optionee to pay the strike price in cash or shares of previously owned vested stock valued on the date of exercise. In the alternative, an optionee often may elect a “cashless exercise,” by which the optionee exercises more shares than actually acquired. Essentially, the optionee purchases all exercised shares at the strike price, and simultaneously relinquishes a portion of these shares with a fair market value equal to the total strike price and, often, applicable taxes.

If tax implications temporarily are ignored, all three payment methods are essentially equivalent in that the optionee’s net worth increases by the same amount. To illustrate, assume that an optionee holds an ISO with a $5 strike price, and exercises 1000 shares when the stock’s fair market value is $100. If the optionee pays the strike price in cash, the optionee remits $5,000 (1,000 exercised shares x $5 strike price) and acquires $100,000 worth of stock (1000 exercised shares x $100 fair market value). The optionee’s net worth therefore increases by $95,000 ($100,000 worth of stock — $5,000 cash paid). If the optionee pays by remitting 50 shares of previously owned stock ($5,000 total strike price) + $100 fair market value), the optionee’s net worth similarly increases by 950 shares (1,000 exercised shares — 50 remitted shares) valued at $95,000 (950 shares x $100 fair market value). Finally, if the optionee elects a cashless exercise, the optionee exercises with respect to 1000 shares and acquires 950 shares {[($100 fair market value – $5 strike price) x 1,000 shares exercised] / $100 fair market value}(5) valued at $95,000.

* Income Tax Implications of Payment

To the extent an option qualifies as an ISO and the optionee makes payment of the strike price in cash, the optionee is not taxed on the acquired stock at exercise, or on the cash remitted as payment. Similarly, if the optionee makes payment by remitting previously owned vested shares, the optionee is not taxed at exercise on the acquired or remitted stock, as long as the remitted shares were acquired other than on exercise of an ISO or, if acquired on exercise of an ISO, held for more than two years after grant and one year after exercise. In this case, an optionee essentially swaps remitted shares for an equal number of acquired shares, so that the tax basis and holding period (for purposes other than disqualifying dispositions) of the remitted shares are carried over to an equal number of acquired shares.(6) The optionee then holds additional acquired shares with a basis equal to zero or cash paid (if any) at exercise, and a holding period that begins on transfer.(7)

Thus, assume as above that (a) in 1998, an optionee is granted an ISO with a strike price of $5; and (b) in 2000, the optionee exercises with respect to 1000 shares when the stock’s fair market value is $100. At exercise, the optionee is not taxed and acquires 1000 shares with a basis $5 per share. Further, assume that (c) in 2003, more than two years after grant and one year after exercise, when the stock’s fair market value is $125 per share, the optionee exercises with respect to an additional 4000 shares and (d) in payment of the strike price, remits shares acquired in 2000. The total strike price in 2003, is $20,000 (4000 shares x $5 strike price) payable by remission of 160 shares ($20,000 / $125 fair market value). The optionee’s $5 basis and three-year holding period in the 160 remitted shares is transferred to 160 acquired shares. The optionee holds the other 3,840 acquired shares with a basis of zero.

If, by contrast, the optionee makes payment of the strike price by remitting previously owned shares acquired on exercise of an ISO prior to expiration of both statutory holding periods, the optionee is not taxed on the acquired shares, but is taxed on the remitted shares. The remission is a disqualifying disposition. Consequently, the optionee is taxed (with respect to the remitted shares) on compensation income equal to the difference between the fair market value (of the remitted shares) at exercise and the strike price. Any additional value (the difference between the fair market value of the remitted shares at disposition and the fair market value of the remitted shares at exercise) is taxed as capital gain.

Thus, in the above example, assume that (c) in 2000, less than one year after the exercise, when the stock’s fair market value is $125 per share, the optionee exercises with respect to an additional 4000 shares and (d) in payment of the strike price, remits shares acquired in 2000. The total strike price on the second exercise is $20,000 (4000 shares x $5 strike price) payable by remission of 160 shares ($20,000 $125 fair market value). Unlike the previous example, however, the remitted shares are a disqualifying distribution and, thus, taxed as if acquired on exercise of a nonstatutory option. Specifically, the optionee is taxed at disposition on $15,200 [($100 fair market value at first exercise — $5 strike price) x 160 remitted shares] of compensation income, and $4,000 [($125 fair market value at second exercise — $100 fair market value at first exercise) x 160 remitted shares] of short term capital gain.

A cashless exercise has essentially the same tax results as remission of shares acquired on exercise of an ISO prior to expiration of the holding periods. In a cashless exercise, the optionee is deemed to purchase all exercised shares at the strike price, and simultaneously deemed to relinquish the number of shares with a fair market value equal to the total strike price plus applicable taxes. Although the optionee is not taxed on the acquired shares, the optionee is taxed on the shares relinquished in a disqualifying disposition. In a cashless exercise, if the optionee’s maximum applicable tax rate is 39.6 percent, the optionee will acquire shares approximately equal to:

Total Exercised Shares — (Total Exercised Shares x StrikePrice)/ Fair Market Value – 39.6% Spread

Thus, in the above example, assume that in 2000, the optionee elects a cashless exercise with respect to 4000 shares, when the stock’s fair market value is $125 per share. The total strike price on exercise is $20,000 (4000 exercised shares x $5 strike price). Pursuant to the above formula, the optionee acquires approximately 3,742 shares {4,000 exercised shares — [(4000 exercised shares x $5 strike price) / ($125 fair market value — 39.6 percent ($125 — $5))]}. Thus, the optionee is deemed to remit approximately 258 shares in a disqualifying distribution, and, consequently, taxed on $30,960 of compensation income [($125 fair market value at exercise — $5 strike price) x 258 shares)]. The fair market value of the remitted shares, which is approximately $32,260 (258 shares x $125), equals the optionee’s total strike price of $20,000 plus applicable federal taxes of $12,260 ($30,960 of income x 39.6 percent rate).

At first glance, neither a cashless exercise nor the remission of stock prior to expiration of the required holding periods seems suitable for exercise of an ISO. Both alternatives defeat the tax advantages of an ISO with respect to shares remitted or deemed remitted. When the alternative minimum tax implications are considered, however, these alternatives may be less objectionable.

Alternative Minimum Tax Implications

Even when exercise of an ISO does not trigger taxable income to an optionee, there are alternative minimum tax (AMT) implications raised by such exercise. In calculating income for AM’r purposes, an optionee must include, in the year acquired stock becomes freely transferable, the difference between the stock’s fair market value at exercise and the strike price.(8)

Assume, as above, that an optionee holds an ISO with a strike price of $5, and exercises with respect to 10,000 vested shares when the stock’s fair market value is $100. Further, assume that the optionee and optionee’s spouse earn wages of $300,000. Thus, their income tax liability is approximately $92,400(9) and their effective AMT rate is 28 percent. For AMT purposes, the optionee must adjust income by $950,000 [($100 fair market value — $5 strike price) x 10,000 shares]. Thus, the optionee’s tentative AMT liability is $350,000 [($300,000 wages + $950,000 ISO adjustment) x 28 percent], and final AMT liability is $257,600 ($350,000 tentative AMT — $92,400 income tax liability).

As noted above, the AMT adjustment for stock acquired on exercise of an ISO is required in the year stock becomes freely transferable. Consequently, if an optionee exercises with respect to unvested shares, the adjustment is not required until the shares vest. At vesting, the AMT adjustment equals the difference between the stock’s fair market value at vesting (not exercise) and the strike price. Thus, with respect to unvested shares, an optionee generally is subject to AMT liability on appreciation between the time of exercise and vesting.

An optionee may be able to avoid AMT liability on appreciation, however, by electing under [sections]83(b) of the Code to apply the AMT adjustment in the year of exercise.(10) If a [sections]83(b) election is applicable to unvested ISO shares, it limits an optionee’s income for AMT purposes to the spread at the time of exercise, instead of at the time of vesting. When exercising an ISO with respect to nonvested shares, however, an optionee may be more concerned with issues other tax implications. By holding unvested shares, an optionee compounds exposure to risk because unvested shares may not be disposed quickly if their value plummets. Moreover, there is a possibility unvested shares will not vest if, for example, the optionee’s employment is voluntarily or involuntarily terminated. Finally, even if a [sections]83(b) election reduces an optionee’s AMT liability in the year of vesting, these savings may not offset the AMT liability paid in the year of exercise once the time value of money is considered.(11)

Avoiding the AMT

Because of problems inherent in incurring AMT liability (including the need for cash to pay the tax and the difficulties associated with the AMT credit, discussed below), an optionee may chose to avoid AMT liability all together. AMT liability is incurred only when an optionee’s tentative AMT liability exceeds income tax liability. By disposing of ISO shares at exercise, in a disqualifying disposition, an optionee may increase income tax liability and, concomitantly, decrease tentative AMT liability. An optionee may avoid AMT liability completely by disposing of enough shares to incur income tax greater than or equal to the tentative AMT liability.

Assume that an optionee exercises an ISO with respect to 12,000 vested shares at a strike price of $5 when the fair market value is $125. The optionee and the optionee’s spouse earn wages and compensation income not attributable to disposition of ISO stock of $300,000. Their income tax liability is 39.6 percent of wages in excess of $278,500 and their effective AMT rate is 28 percent. On exercise of an ISO, the optionee may avoid AMT liability by disposing of shares equal to:

.707088 x Total Exercised Shares + (66,703 – .2929 Wages)/ (FMV – Strike Price)

In this example, the optionee avoids AMT liability on disposition of approximately 8,309 shares {.707088 x 12,000 + [(66,703 – .2929*$300,000) / ($125 fair market value — $5 strike price)}.

More specifically, the optionee’s income tax liability is:

Salaries $ 300,000

Compensation due to disposed

ISO shares 8309 shares x $120 spread $ 997,080

Taxable income $ 1,297,080

Tax on $278,500 of income $ 83,850

Tax on additional $1,018,580

of income @ 39.6% $403,357.68

Income tax liability $487,207.68

The optionee’s tentative AMT liability is:

Salaries $ 300,000

Compensation due to disposed

ISO shares 8309 shares x $120 spread $ 997,080

ISO adjustment due

to retained shares 3691 shares x $120 spread $ 442,920

AMT income $ 1,740,000

Tentative AMT

liability @ 28% approximate $ 487,200

If the spread between the strike price and the stock’s fair market value at exercise is relatively large, an optionee will need to dispose of a significant portion of exercised shares to avoid AMT liability. For investment reasons, however, an optionee may want to retain vested shares and, thus, incur some AMT liability. In weighing whether to dispose of shares or incur AMT liability, an optionee should consider diversification strategies, the possibility the stock’s value will increase or decrease significantly, the tax advantages of incurring capital gains in later years (rather than compensation in the current year), the difficulties associated with using an AMT credit, and, possibly most significantly, the need for cash to pay the strike price, income tax and/ or AMT liability. Although an optionee may borrow funds for this purpose, a loan compounds exposure to the stock; if the price plummets, the optionee could be left with insufficient funds to repay the loan and interest. Consequently, an optionee should consider disposing of at least of enough shares to obtain cash sufficient to pay the strike price and applicable taxes.

Without considering an optionee’s withholding and estimated tax payments, an optionee obtains cash sufficient to pay the strike price and federal taxes by disposing of shares equal to:

[Total Exercised Shares (.72 Strike Price + .28 Fair Market Value)] + .28Wages / Fair Market Value

In the above example, the optionee obtains cash sufficient to pay the strike price and federal taxes by disposing of approximately 4,378 shares: {[[12,000 shares exercised (.72 x $5 strike price + .28 x $125 fair market value)] + .28 x $300,000] / $125}.

More specifically, the optionee’s income tax liability is:

Salaries $ 300,000

Compensation due to disposed

ISO shares 4378 shares x $120 spread $ 525,360

Taxable Income $ 825,360

Tax on $278,500 of income $ 83,850

Tax on additional $546,860

of income @ 39.6% $216,556.56

Income tax liability $300,406.56

The optionee’s tentative AMT liability is:

Salaries $ 300,000

Compensation due to disposed

ISO shares 4378 shares x $120 spread $ 525,360

ISO adjustment

for retained shares 7622 shares x $120 spread $ 914,640

AMT income $ 1,740,000

Tentative AMT

liability @ 28% approximate $ 487,200

Final AMT liability $487,20-$300,407 $186,793.44

On disposition, the optionee obtains $547,250 (4378 disposed shares x $125 fair market value), sufficient to pay the $60,000 strike price (12,000 exercised shares x $5 strike price), $300,407 income tax liability and $186,793 AMT liability.

The AMT Credit

Although an optionee may incur AMT liability on exercise of an ISO, AMT does not increase the optionee’s basis in acquired stock. The AMT paid may be recoverable, however, in whole or in part, through the AMT credit, which equals a taxpayer’s AMT liability paid. The credit is carried forward and claimed against income tax, but only to the extent income tax liability exceeds AMT liability.

As in the prior example, assume that in 2000, the optionee exercised an ISO with respect to 12,000 shares, immediately disposed of 4,378 shares at the fair market value of $125, and retained 7,622 shares. Also, assume that the optionee incurred AMT liability of $186,793 which amount is carried forward as an AMT credit. In 2001, more than two years after grant and one year after exercise, the optionee sells 7,622 shares for $150 per share. In the same year, the optionee and optionee’s spouse earn wages and compensation income not attributable to disposition of ISO stock of $300,000.

For income tax purposes, the optionee’s gain on the sale of stock is $1,105,190 [($150 sale price — $5 basis) x 7622 shares]. For AMT purposes, the optionee’s gain on the sale of stock is $190,550 [($150 sale price — $125 fair market value at exercise) x 7622 shares). The $914,640 difference between the optionee’s gains for income tax and AMT is a negative adjustment to AMT income in the year of sale.

Thus, the optionee’s income tax liability in 2001 is:

Salaries $ 300,000

Tax on first $278,500 of income $ 83,850

Tax on additional $21,500 of income @ 39.6% $ 8,514

$ 92,364

Long term capital gain 7622 x $145 gain $ 1,105,190

Capital gain tax @ 20% $ 221,038

Total income tax liability $ 313,402

The optionee’s AMT liability in 2001 is:

Salaries $ 300,000

Long term capital gain 7622 x $145 gain $ 1,105,190

Negative AMT adjustment ($914,640)

AMT income $ 490,550

AMT compensation income $ 300,000

AMT liability @ 28% approximate $ 84,000

AMT capital gain $1,105,190 – $914,640 $ 190,550

Capital gain liability @ 20% $ 38,110

Tentative AMT liability $84,000 + $38110 $ 122,110

In the year of sale, the optionee’s income tax liability ($313,402) exceeds tentative AMT liability ($122,110) by $191,292. The optionee may apply, against this excess income tax liability, the entire $18,$,793 AMT credit.

For many optionees, AMT liability equals or exceeds income tax liability in most tax years. Consequently, an AMT credit is difficult to use. The credit generally remains largely unused until a year in which the taxpayer incurs a large negative AMT adjustment (e.g., the sale of ISO stock). This adjustment may be several years after the AMT liability is incurred. Moreover, if the ISO stock that generate the AMT credit decreases in value after exercise, the optionee’s negative AMT adjustment similarly would decrease, and the AMT credit could remain largely unused. Although AMT credits may be carried forward indefinitely, the actual value of a credit may be minimal once the time value of money is considered. In addition, the unlimited carry-forward requires an optionee to maintain records of the credit’s origin and applications.

Tax advisors must be careful when counseling a holder of an ISO, especially if the optionee’s strike price is significantly less than the stock’s fair market value. Advisors must compare the income tax consequences of an optionee disposing of stock at exercise, with the disadvantages of incurring AMT liability. These issues then must be weighed against the optionee’s investment and diversification goals limits under the securities laws, need for cash to pay costs and taxes, and career plans. In balancing all these issues, tax advisors should consult with financial planners and securities experts.

(1) IRC [sections] 83 (1986, as amended); see Regs. [sections] 1.83-7(a)-(b) (a nonstatutory option triggers income at grant only if it has a readily ascertainable value, which ordinarily must be determined by trades on an established market).

(2) IRC [sections] 421.

(3) IRC [sections] 423.

(4) See IRC [sections] 422.

(5) In a cashless exercise, prior to taxes, an optionee acquires shares equal to (i) the excess of the stock’s fair market value over the strike price (ii) multiplied by the number of shares exercised and (iii) divided by the stock’s fair market value.

(6) See IRC [sections] 1036.

(7) Prop. Regs. [sections] 1.422A-2(i)(1)(iii).

(8) IRC [sections] 56(b)(3). In general, vested shares become freely transferable at exercise, unless the optionee’s right to transfer acquired shares is restricted by the securities laws or otherwise.

(9) Calculations are based on 1998 federal income tax rates for married taxpayers filing jointly.

(10) It is unclear whether a [sections] 83(b) election is applicable to the exercise of an ISO with respect to restricted shares. Neither the Code nor the Regulations specifically address this issue. Although [sections] 83 does not apply to transactions governed by [sections] 421 (which generally governs the taxation of ISOs at exercise), [sections] 421 does not apply to ISOs for purposes the AMT. IRC [subsections] 83(e)(1), 56(b)(3). Moreover, the legislative history to the 1988 Technical and Miscellaneous Revenue Act, which implemented the AMT adjustment for ISOs, states that, for purposes of the AMT, stock acquired on exercise of an ISO is governed by [sections]83. TAMRA [sections] 1007(b)(14)(A). Thus, it is reasonable to assume that a [sections] 83(b) election is allowed with respect to unvested stock acquired on exercise of an ISO. In any event, the election would apply only for AMT purposes, not income tax purposes.

(11) See “Global Investment Strategies,” Sanford C. Bernstein & Co., Inc., 1999.

Allison Rogers is an associate with Rogers, Bowers, Dempsey and Paladino, West Palm Beach. She previously was employed by the Office of Chief Counsel, Internal Revenue Service. She earned her law degree from Georgetown University and attended New York University’s program for masters in taxation.

This column is submitted on behalf of the Tax Section, David E. Bowers, chair, and Michael D. Miller and Lester B. Law, editors.

COPYRIGHT 2000 Florida Bar

COPYRIGHT 2008 Gale, Cengage Learning