Question: I was granted incentive stock options and non-qualified stock options from my company prior to the time the company went public. Can you explain the tax consequences and whether I am better off buying and holding the stock or doing cashless exercises?
Answer: For tax purposes, there are three relevant time periods to consider with respect to stock options, the date the stock option is granted, the date the stock option is exercised and the date the stock acquired with the stock option is sold. Unless the stock options themselves are publicly-traded or otherwise have a readily ascertainable fair market value, the grant of a stock option is not a taxable event. Typically, the taxable event will occur when the stock option is exercised and the shares are acquired for the option price. At such time, income must be reported based on the difference between the fair market value of the stock acquired and the exercise price of the stock option. This income will be taxable at ordinary income tax rates. Payroll taxes will also be imposed on the income reported.
In the case of an incentive stock option (an “ISO”), income need not be reported at the time the stock option is exercised. The taxation of stock acquired with an ISO occurs at the time the shares acquired through the exercise of the ISO are sold. In this case, income can be taxed at favorable taxable gains tax rates. The many statutory rules that must be satisfied for ISO treatment include a requirement that the shares acquired through the ISO exercise may not be disposed of within two years of the date of the granting of the corresponding stock option nor within one year of the issuance of the shares to the holder. Another requirement is that the recipient of the ISO must have been an employee of the issuing corporation during the period beginning on the date of the granting of the option and ending on the date three months before the option is exercised. Despite the attractiveness of ISOs from an employee’s perspective, ISOs have become less common since employers are no longer entitled to a deduction for the compensatory element of ISOs.
Many employees are concerned that they cannot fully benefit from stock option programs as they lack the funds needed to acquire company stock with the option. As with many stock option plans, your plan presumably permits a so-called “cashless exercise” whereby employees can receive the difference between the fair market value of the stock and the exercise price without actually purchasing stock with the option. Although ordinary income and employment taxes will still be imposed, employees need not part with cash to obtain the benefit of the bargain.
As an initial step, you should first determine how much of your employer’s stock you are capable of purchasing and comfortably holding for investment. These shares should be acquired with ISOs as you can defer paying tax on the income until the shares are sold and possibly benefit from favorable capital gains tax rates upon sale. If you wish to acquire more shares than you can purchase with ISOs, then you can use your non-qualified stock options to acquire the shares but you will be taxed on the spread between the option price and the stock’s fair market value at the time of the exercise. In this case, post-exercise appreciation in the value of the stock may be taxable at capital gains tax rates if you sell the shares and satisfy the capital gain holding period. To the extent there are any other options you hold for which you do not intend to acquire shares, you can utilize the cashless exercise feature to benefit from the stock options.
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