By Kenneth H. Bridges, CPA, PFS March 2011
With the corporate accounting scandals of the past few years and the bursting of the stock market bubble in 2000, stock options have lost some of the luster they held in the 1990s. However, they continue to be an important element of compensation, with potentially significant tax ramifications; both for the issuing companies and the employees who hold them.
Stock options essentially come in two flavors: nonqualified stock options (NQSOs) and incentive stock options (ISOs). With either type of option, there is typically no event of taxation at the time of grant. With NQSOs, the employee has ordinary compensation income at the time of exercise equal to the spread between the market value of the stock on the day of exercise and the exercise price (the “bargain element”). The employer corporation gets a tax deduction in like amount. With ISOs, for “regular” tax purposes, exercise does not trigger taxation, and, so long as the employee holds the stock at least one year from the date of exercise and two years from the date of grant of the option, all of the gain is taxed as long-term capital gain. In this case, the employer corporation does not get a tax deduction.
The beauty of stock options is that they enable the holder to enjoy the appreciation in the value of the stock without putting any capital at risk. For this reason, you typically will not want to exercise a stock option until an event of liquidity occurs and you are ready to sell the underlying stock. However, there are exceptions to this general rule. For example, if the company is paying significant dividends it may be prudent to exercise the options in order to become a stockholder and capture the dividend. More typically, however, the decision to exercise options prior to time of sale of the stock will be tax driven.
If both the exercise price and the current value are fairly low, and you are optimistic about the future of the company, then exercising early will likely be prudent in order to get your holding period running for long-term capital gains and minimize any ordinary income you will incur. On the other hand, if either the exercise price or the tax liability that will be incurred upon exercise are substantial relative to your net worth, you will typically need to continue to hold the options until the event of liquidity and accept that the eventual tax bite may be substantial.
ISOs hold out the promise of being able to potentially convert what would otherwise be ordinary income (taxed at the highest rates) into long-term capital gain (taxed at more favorable rates). However, because the bargain element is an “alternative minimum tax” (AMT) adjustment on the date of exercise, the AMT often eliminates much of the hoped for benefit. This represents a potentially disastrous situation for those who do not navigate these rules carefully. In 2000, many holders of stock options in tech companies learned this the hard way. These individuals exercised deep in-the-money ISOs in 1999 at a time when the stock market was near its peak and held onto the stock, resulting in a substantial alternative minimum tax liability for 1999. By the time they sold the stock in 2000, the price had collapsed, leaving them in a situation where their tax liability from the AMT exceeded the proceeds from selling the stock. In some cases, individuals were financially ruined by the AMT.
If you exercise and sell in the same tax year, then the AMT issue goes away. Accordingly, we typically advise our clients who want to exercise and hold ISOs to do so early in the year, giving us almost a full year to watch the stock price and to sell the stock before year end if necessary in order to cure the AMT problem. If the stock price stays up or rises, then the client can sell the shares in the early part of the next year and enjoy long-term capital gain treatment on the full amount of the gain. In a situation where a client has capital loss carryforwards, this can actually result in going from a 40% effective tax rate to a 0% effective tax rate on the stock gain.
Exercising and holding ISOs can be a good strategy in a year in which you otherwise have a substantial amount of ordinary income. Because the regular tax rate goes up to 35% but the AMT rate caps out at 28%, in a year of substantial ordinary income (e.g. a substantial bonus or W-2 income from exercise of NQSOs) a spread can be created between regular tax and AMT which creates an opportunity to exercise ISOs at no tax cost. Of course, consideration must still be given to your comfort level with putting at risk the amount of the exercise price and the potential opportunity cost of deferring the sale of the stock for another year, but if you are comfortable with these risks the potential tax savings can be substantial.
Kenneth H. Bridges, CPA, PFS is a partner with Bridges & Dunn-Rankin, LLP an Atlanta-based CPA firm.
This article is presented for educational and informational purposes only, and is not intended to constitute legal, tax or accounting advice. The article provides only a very general summary of complex rules. For advice on how these rules may apply to your specific situation, contact a professional tax advisor.