Stock Option Path to Riches - Part 2

This column, in slightly different format, originally appeared in The San Francisco Examiner Newspaper, January 31, 1999

Copyright 1999 Robert L. Sommers, all rights reserved.

Introduction

The taxation of statutory vs. non-statutory stock options, each a modern employee benefit, can be confusing. [See the last column for details about non-statutory stock options]. Last column’s example involved Joe Cobal, a computer engineer who went to work for Start-Up on January 1, 1994. For each year (12-month period) he worked, Joe would receive an option to purchase 50,000 shares of Start-Up, at a penny ($.01) per share. Each option would expire 10 years later. The company's current stock value was ten cents ($.10) a share, but was not publicly traded. The options had no other restrictions. Three years after he commenced work, Public bought Start-Up for $20/share.


Statutory options (which are governed by the Internal Revenue Code) receive favorable tax treatment. A statutory stock option plan is either an incentive stock option ("ISO") or an option granted under a company’s stock-purchase plan.

With either plan, generally, the employee suffers no tax consequences, either upon receipt or exercise, and the employer receives no deduction. If the option is exercised and the stock received is held for 12 months or more before it is sold, the employee usually has long-term capital gains (LTCG) and is taxed at a maximum of 20% federal. Under the stock-purchase plan, however, part of the gain may be taxed as ordinary income. [Note: California taxes LGCG as ordinary income.]


Incentive Stock Options

ISOs are granted by a corporation (or its parent or subsidiary) to an individual in connection with employment. The option price cannot be less than the FMV of the optioned stock at the time the ISO is received and must be excercisable within 10 years from receipt. Also, the employee cannot already own more than 10% of all classes of stock, by vote or value, of the company or its parent and subsidiary companies.

Once an ISO is exercised, the employee is taxed at the LTCG rate on the stock, provided he does not sell the stock for at least (1) two years after the option was granted; and (2) one year after exercising the option. These holding requirements are waived if the employee dies. Also, the FMV of stock subject to an exercisable ISO cannot exceed $100,000 in any one calendar year.

An employee must remain employed by the employer (its parent or subsidiary) from the time the option is granted until at least three months before exercise. Also, an employee has up to three months after termination of employment to exercise an ISO. For disabled employees, the post-termination period is extended to 12 months and is waived completely upon death.

Failure to meet these holding requirements causes the gain to be taxed as ordinary income, determined at the time the option was exercised. The gain is usually the value of the stock on date of exercise minus the option price. The company is entitled to a deduction at the time the employee recognizes the income from the premature disposition.

If Joe received an ISO, then he would need to wait until the following dates to receive LTCG treatment:

Date ISO Received

Date of Exercise

(on or before)

Date of Stock Sale LTCG treatment

(on or after)

12/31/94

12/31/95

12/31/96

12/31/95

12/31/96

12/31/97

12/31/96

12/31/97

12/31/98

For example, if Joe sold all his stock to Public on January 2, 1997 for $20/share (assuming he exercised his stock options upon receipt) , he’d receive LTCG treatment on 50,000 shares ($1,000,000) and 100,000 shares ($2,000,000) would be taxed as ordinary income.


Stock Purchase Plans

Under these plans, if the option price is not less than 85% of the stock’s FMV when acquired (at grant) or at the time of exercise, then, in general, the difference between the option price and the FMV of the stock at the time of the grant is taxed as ordinary income. For example, suppose Joe acquired options to purchase Start-Up’s stock valued at $10/share for $8.50/share. If he exercised his option then sold the stock at least 12 months later (and at least 24 months after grant) for $25/share, then $1.50/share would be taxed as ordinary income and the balance ($15/share) would be capital gains.

The option must be exercised within 27 months of grant. This period is extended to five years if the option price is at least 85% of the stock’s FMV when the option is actually exercised. Also, no employee may receive options for more than $25,000 of stock per year, calculated when the option is received. The employee cannot already own more than 5% of all classes of stock, by vote or value, of the company, or its parent and subsidiary companies. There are other statutory requirements similar to those of ISO’s.


Alternative Minimum Tax

When an ISO is exercised, the "spread" (the difference between the stock value and option price) is a positive "adjustment" under alternative minimum tax ("AMT") rules.

In Joe's situation, the value of Start-Up's stock over the option price, $4,500, is a positive adjustment under AMT rules. Generally, a spread this small will not trigger the AMT. If, however, Start-Up's stock is increasing in value, Joe should consider exercising his stock options as soon as possible.


A Short-Hand Method to Avoid the AMT

Note: Use Form 1040 (regular tax) and Form 6351 (alternative minimum tax) to perform this calculation. Determine your regular tax (assume $20,000) and your alternative minimum tax (assume $15,000). Subtract the difference ($5,000) then divide the $5,000 by the AMT tax rate of 26% ($19,230). Divide the $19,230 by the spread (assume $10) = 1,932 shares may be exercised without triggering the AMT.

Regular Tax (Form 1040)

$20,000

AMT (Form 6351)

$15,000

Difference

$5,000

Divide by AMT rate (26%)

$19,230

Divide by Spread per share

$10

Maximum Number of Shares that may be exercised without AMT

1,923


Conclusion

Stock options are powerful incentives with potentially huge payoffs, provided the employee understands how his or her particular company plan works and the tax consequences. For start-ups, the non-statutory stock option with immediate vesting, is probably the best alternative. Be sure to exercise the option once the spread becomes taxable to you. To obtain the maximum capital gain with a favorable tax rate, you must hold the stock at least 12 months.

Statutory stock-option plans have advantages as well. There is no ordinary income tax element upon receipt or exercise, and the subsequent stock sale may offer advantageous LTCG treatment. With an ISO, carefully calculate the AMT consequences.




 

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