Exercising stock options without cash: a survey of what's available.by Zesk, Thomas J.
A number of techniques are being used to allow executives to exercise stock options without paying cash. These so-called cashless exercises have become very popular since they eliminate the need to borrow or to liquidate assets in order to exercise an option.
The most commonly used technique is the exercise of an option with existing stock owned by the option holder. However, where shares are not currently held, a series of variations have recently been introduced whereby the exercise price is essentially paid with a portion of the shares acquired upon exercise.
Cashless Exercise Using Existing Shares
As noted above, the most common form of cashless exercise involves the use of existing shares to exercise an option. For example, if an executive holds an option to acquire 10,000 shares at $10 a share, (total exercise price of $100,000) and the market value is $25 a share, the executive would need 4,000 existing shares ($100,000 divided by $25) to meet the $100,000 exercise price. The pretax increase in net worth after exercise is equal to $150,000, i.e., the 6,000 net increase in shares at $25 market value. This is the same increase as would result from a cash exercise, except that a stock exercise does not entail any shifting of investments or borrowing of funds.
For tax purposes, such stock exercise is treated as two separate transactions: 1) a tax-free exchange of 4,000 old shares (in the above example) for 4,000 new shares; and 2) the receipt of compensation income of $150,000 equal to the value of the incremental 6,000 shares. The 4,000 shares received in the exchange transaction will have the same basis and holding period as the 4,000 old shares given up. The 6,000 incremental shares have a basis equal to the amount included in income. A new holding period starts for these shares.
A non-insider (under SEC rules) would be subject to tax on the $150,000 upon exercise, as with a cash exercise. However, an insider who does not make the special Sec. 83(b) election would be subject to tax in six months.
As a variation of an actual stock exercise, the IRS has ruled that the same tax treatment would result if a non-qualified option is "constructively" exercised with existing shares. In a constructive stock exercise, the option holder would not have to actually deliver his existing shares in order to exercise an option with existing stock. Instead, the option holder would provide a notarized letter stating the fair market value of the existing shares being used. The issuing corporation would then issue the incremental shares. The amount of incremental shares would be equal to the difference between the number of shares for which the option is exercised and the number of shares used to exercise the option.
Pyramiding: Progressive Exercise with Existing and New Shares
If an option holder does not have sufficient existing shares, he or she can achieve the same result as a stock exercise with a "pyramiding" technique. Pyramiding is a series of progressive stock exercises, typically starting with a small amount of shares (which could be acquired in a cash exercise), and using the shares acquired upon prior exercises to effect the exercise of the additional shares under the option. The end result is the same as a one-shot exercise with existing shares: an increase in net worth (and taxable income) equal to the value of the incremental shares.
The tax treatment of a pyramiding exercise scheme is the same as with a one-shot stock exercise. The incremental shares remaining at the end are subject to tax at their fair market value (less any cash paid if the pyramid was started with a cash exercise). An insider who does not make a Sec. 83(b) election would be taxed in six months.
The Immaculate Exercise: Reduction of Shares Received Upon Exercise
As an alternative when the option holder does not currently own shares, the following simple technique has been used if options are exercised directly with the issuing employer (without broker involvement): Upon exercise, the option holder instructs the issuer to withhold from the shares which would otherwise be issued, the amount necessary (at current market value) to satisfy the exercise price. In effect, only the incremental shares are issued upon exercise. This places the option holder in the same position from a tax and net worth viewpoint as would a stock exercise or pyramiding exercise.
Broker-Financed Stock Exercise
A fairly recent alternative to the above-noted cashless exercise requires the involvement of a broker. A recent amendment to Federal Reserve regulations allows a broker to temporarily finance the exercise of a stock option using a signed exercise notice as collateral. Under this technique, the option holder submits an exercise notice to the issuer and the broker, with instructions to the issuer to deliver shares to the broker. The broker then advances funds equal to the exercise price to the issuer in return for shares, and retains enough shares at the current market price to satisfy the loan and pay the broker's commission. The remaining shares are transmitted to the option holder.
If the option holder is not an insider under SEC rules, the broker typically sells the shares he or she retained in connection with the loan. However, for an insider, the broker would establish a margin account for the option holder, with the margin loan to be repaid at the end of the six month period.
For tax purposes, it would appear that this should be treated as a loan to the option holder by the broker, followed by a cash exercise of the option. The loan is repaid with the shares obtained upon exercise. For an insider, the shares are used to collateralize the margin account until the six month restriction period lapses.
In any of the above noted cashless exercise techniques, it is possible to use existing shares to satisfy withholding tax triggered by the exercise. This should result in a sale of the existing shares for tax purposes. Alternatively, the option holder could simply direct the issuing employer to withhold from the shares to be issued the amount necessary (at current market value) to satisfy the withholding tax. In the broker-financed transaction, the broker loan could be increased to cover the tax liability.
Application to Incentive Stock Options
Generally, the principles discussed in this article pertain to non- qualified stock options. The cashless exercise techniques are also available with respect to Incentive Stock Options (ISOs). An exception might be the constructive exercise techniques (which were only specifically approved for use with non-qualified options). The tax treatment of these techniques with respect to ISOs will differ from that of non-qualified options and must be separately analyzed.
New SEC "Insider Rule" Proposals
As a final note, the SEC is proposing new rules that would simplify the treatment for insiders in the transactions described above. Essentially, under these proposals, the restriction on a sale of stock by an insider within six months of a purchase would be eliminated. Therefore, an exercise of an option by an insider would be subject to tax upon exercise rather than six months later, since the acquired shares could be immediately sold.
There are a number of alternatives available, depending on the particular situation, whereby an executive can exercise a stock option without a cash outlay. Each technique would generally result in similar tax and economic implications. Of course, in order for these techniques to be available, the terms of the stock option plan must provide for them.
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