By Sonja Lepkowski, CFP, CPA, Yohalem Gillman & Company, LLP
Stock options, in the form of deferred compensation, are a major component of executive pay. They also serve as retirement payments and incentive to stay during transitions of executive responsibility or corporate control. In today’s world, however, stock options are no longer solely for corporate executives; rank and file workers as well as management now receive stock options when their companies go public or merge with other companies. Stock options can be an enticement to accept a different job or a powerful incentive to stay, offering the possibility of enhanced compensation and early retirement. Once found only in corporate finance, stock options are beginning to appear in accounting firms, for both current and prospective employees.
The two primary types of compensatory stock options, incentive stock options (ISOs) and non-qualified stock options (NQSOs), receive different treatment for tax purposes.
Incentive Stock Options
ISOs (covered in IRC sections 421 and 422) are granted to current employees only. No tax is withheld at any stage: neither when the ISO is granted, nor when it is exercised and sold. To qualify as an ISO, the option price cannot be less than the market price of the stock on the date granted.
The ISO entitles the employee, or optionee, to purchase the stock of the employer, subsidiary, or parent at a fixed price, called the exercise price, which must be exercised within 10 years of the grant date of the option. Generally, the optionee on the date of grant cannot own more than 10% of the total combined voting power of all classes of the stock. However, this restriction does not apply if the option price on the grant date is at least 110% of the fair market value of the underlying ISO stock on the same date and if the option is not exercisable after five years from the grant date.
The ISO must be exercised while the optionee is employed by the grantor (or by a related entity), or within three months (12 months if the employee is disabled) of termination. The optionee must pay the exercise price in order to buy the stock. If the optionee has neither the cash to exercise the option nor access to a margin account (see below), arrangements may be made with a brokerage firm to allow the optionee to finance an option exercise of a publicly traded stock with a same-day sale of the acquired stock at the market price.
The optionee has no tax consequences on the date the ISO is granted. For regular income tax purposes there is no tax on the date the options are exercised; however, for AMT purposes, there is an increase in taxable income when the fair market value of the stock acquired exceeds the exercise price. If the stock is not sold during the calendar year in which the option is exercised, that excess is included as an increase in income on Form 6251. If the stock is sold in the calendar year in which the options were exercised, then the excess is taxable both for AMT purposes and for regular income tax purposes. No adjustment is required, as the regular tax calculation already includes the income.
If the AMT is triggered by exercising an ISO, the tax law provides an AMT credit against regular tax in subsequent years, but only to the extent that the regular income tax exceeds the tentative AMT. The credit is claimed on Form 8801.
The difference between the proceeds and basis upon the sale of the stock is a capital gain or loss, taxable for regular tax purposes. The optionee must satisfy two holding periods in order to receive long-term capital gain treatment for the sale of stock previously acquired by an ISO exercise: The date of sale must be both more than 12 months after the ISO exercise date and more than two years after the grant date.
If the stock price declines below the option price after the date of ISO exercise, IRC section 422(c)(2) provides that the optionee does not recognize any ordinary income but instead recognizes a capital loss in the year of sale on the difference between the proceeds from the sale and the exercise price, which is the basis in the stock.
Non-Qualified Stock Options
NQSOs (covered under IRC section 83) can be granted to employees and others, including directors, consultants, and independent contractors. The recipients of NQSOs do not recognize taxable income on the grant date when the option does not have a readily ascertainable fair market value, even if the exercise price is below the market price of the stock. If the fair market value of an NQSO is ascertainable, there will be taxable income at the time of the grant. An option will be considered to have a readily ascertainable value, even if not publicly traded, if all of the following conditions are met:
Ordinary income (compensation) is recognized on the date that the option is exercised and is subject to income, Social Security, and Medicare taxes, whether or not the stock is sold (unless the SEC places a restriction on when the stock can be sold, known as a “blackout period”). In this case, ordinary income is recognized when the restriction ends, unless within 30 days of the option exercise the optionee elects to recognize the income on the date of exercise under IRC section 83(b). The amount of ordinary income recognized is the excess of the fair market value of the stock over the exercise price.
Because of the taxes, NQSOs are best exercised when the stock price is at a low point. The optionee intending to hold the stock must be prepared to pay both the exercise price to purchase the stock and the required taxes. If an optionee does not have sufficient funds to pay the exercise price and the taxes but has other marginable securities, a margin account loan can fund the exercise price and the taxes. (The options themselves are not marginable.) After exercising the option, if the resulting new stock is marginable, its fair market value may be aggregated with the other marginable securities to reduce the overall margin percentage. Depending on the amount of leverage, margin calls can result if the stock declines in value. If the optionee has no marginable securities or chooses not to use other funds, a cashless transaction, as described above, must be utilized.
The fair market value of the stock on the date of the option exercise is the basis of the stock acquired (the ordinary income recognized plus the exercise price). The difference between the proceeds from the sale and the basis of the stock that is sold is either a short-term or a long-term capital gain, depending on the holding period.
When to Exercise Options
The voluntary exercise of compensatory stock options in the years before their expiration dates is rare, since options become more valuable as time goes on and holding the options defers the payment of income taxes. However, exceptions exist, such as when the optionee—
Alternatively, the optionee may want to exercise the options early to convert future appreciation from ordinary income to capital gains. It is also possible to retain the NQSO and buy the stock outright with sufficient liquidity, allowing the optionee to retain the advantages of holding the option while gaining the benefits of owning the stock.
Optionees of ISOs should not exercise their options if they plan to hold the stock for more than 12 months and one day. There is no income tax advantage after that time, because of the long-term capital gain holding period requirements.
When to Sell the Stock
ISOs. Exercising ISOs and selling the stock 12 months and
one day later is most appropriate when—
However, the optionee assumes the risk that the value of the stock will decline.
NQSOs. The optionee should sell the stock when the long-term capital gain tax rates apply, if possible, without risking future decline in fair market value of the optioned stock. Alternatively, a sale immediately after exercise will result in compensation and avoid any future risk of reduction in capital.
Estate and gift tax consequences. The optionee cannot transfer an ISO other than by will or by the laws of descent and distribution. The option retains its status as an ISO in the hands of the estate or heirs that succeed to the option, subject to all of the statutory provisions governing ISOs except the employment and holding period requirements.
If a donor seeks to make a charitable contribution of stock acquired through the exercise of an ISO, a deduction at fair market value results, provided that the donor has held the stock for—
NQSOs may be transferred during the life of the optionee to certain family members or trusts for their benefit, or even to charitable organizations, provided that the stock option plan permits such a transfer. Gifts to a noncharitable beneficiary should be completed as soon as possible to fix the value of the transfer as low as possible. Revenue Procedure 98-34 establishes a safe-harbor method of valuing an NQSO for gift, estate, and generation-skipping tax purposes.
Robert H. Colson, PhD, CPA
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