Employee Stock Options – Year End Planning - Part 1

This column, in slightly different format, originally appeared in The San Francisco Examiner Newspaper, November 12, 2000.

Copyright 2000  Robert L. Sommers, all rights reserved.

Part 1 of a 2-part series

Employee Stock Options – Year End Planning

As part of his compensation package with Acme.com, on January 1, 1999, Joe received 25,000 incentive stock options (ISO) and 20,000 non-qualified stock options (Non-Quals), along with an annual salary of $100,000. [See sidebar for description of terms.] Joe is single and rents an apartment. On May 2, 2000, Joe exercised 10,000 ISO when Acme.com’s stock was trading at $100/share. The stock is now worth $30/share.

Question: Should Joe be concerned with taxes in 2000, even though he has not sold any Acme.com stock, and if so what is his tax bite?

Answer: Joe could have a very high tax bill. The moment he exercises any of his ISOs, a potential Alternative Minimum Tax (AMT) liability is triggered on the difference between what he paid and what the stock is worth on the date of exercise. In addition, no money is withheld by Joe’s employer to help pay for his pending tax on the stock, so he had better be prepared with cash on hand by April 15, 2001.

Alternative Minimum Tax -- Exercising the
Option Causes Tax Liability

Once you exercise ISOs, you cause a taxable event and you could pay AMT on the stock received. So, whether the value of his stock increases or decreases from that date forward, Joe could owe the AMT on the stock’s value on the date he exercised his options.

When Joe exercised 10,000 ISOs in May, he generated a $1 million paper gain (10,000 shares x $100/share = $1 million) even though he did not sell any shares. This gain is not reported under the regular tax system, but is considered a "tax preference" item under the murky AMT, a shadow tax system, activated when a taxpayer has tax preference items over a certain threshold. In Joe’s case, the federal AMT is $281,000 and the California AMT is $69,500 for a combined tax of $350,500. The tax is payable April 15, 2001, even through the share price of Acme.com has dropped 70% from the exercise date of May 2, 2000 and is now worth only $300,000.

NOTE: The balance of this article has been incorporated into the Tax Prophet's Action Guide entitled, "Employee Stock Options - A Primer" described below:

Employee Stock Options - A Primer

This Action Guide is the product of the author's extensive experience in negotiating stock options as part of the compensation package paid to employees and contractors. In addition, the author represents several taxpayers who confronting huge tax bills stemming from the exercise of employee options and the subsequent crash of the stock market.

This Action Guide defines the key terms and concepts involving both incentive stock options (ISO's) and non-qualified stock options, identifies the tax-triggering events and discusses strategies to minimize the tax impact. The guide discusses the alternative minimum tax as applied to ISOs as well as sophisticated tax-planning concepts. This guide is a must read for employee or company that receives stock options as part of their compensation.

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All contents copyright 1995-2003 Robert L. Sommers, attorney-at-law. All rights reserved. This internet site provides information of a general nature for educational purposes only and is not intended to be legal or tax advice. This information has not been updated to reflect subsequent changes in the law, if any. Your particular facts and circumstances, and changes in the law, must be considered when applying U.S. tax law. You should always consult with a competent tax professional licensed in your state with respect to your particular situation. The Tax Prophet® is a registered trademark of Robert L. Sommers.