Stock and stock options are non cash compensation granted to employees (Usually executives) as a form of incentive to achieve superior performance on behalf of the employer. These are granted in several different forms and depending on whether they are classified as qualified or non-qualified, have tax implications to the employer and the employees.
Stock Options: Options give the executive the right to purchase (exercise) a fixed number of shares of employer stock at a specific, predetermined price (exercise price) over a stated period. When it is granted, if it has no value then no tax is due. This is usually the case when the option’s exercise price is equal to the stock price at the time the options are granted. Subsequent tax treatment of the options differs depending on whether they are non-qualified stock options (NQSO) or incentive stock options (ISO), which are tax qualified.
Non-qualified stock options (NQSO): On the date of exercise, the difference between the then stock price and the exercise price (Called bargain element in tax parlance) is taxed as ordinary income to the employee. The taxable basis of the stock is the option exercise price plus the ordinary income recognized. The stock’s holding period for determining capital gains treatment, when it is sold starts from the date of exercise.
Incentive stock options (ISO): On the date of the exercise, there is no taxable event for the executive. However, for the calculation of AMT (Alternative Minimum Tax), the bargain element is reported as an AMT preference item (This can be refunded against future income tax burden). If the acquired stock is not sold for at least one year after exercise and two years after grant, then any gain in the value of the stock (More than exercise price) is treated as long term capital gains. Long term capital gains are taxed more favorably and depending on the executive’s compensation level, the difference between taxation of long term and short-term capital gains can be substantial. If the exercised stock is not held for at least one year after exercise and two years after grant, then this ‘disqualifying disposition’ results in ordinary income tax on the bargain element and capital gains (Usually short term) for gains over the exercise price.
Things to consider: Some of the strategies for managing options are diversification, wealth accumulation and tax minimization.
Many executives who are granted NQSOs or ISOs tend to ignore the tax aspect of these options. Others tend to let the tax ‘tail’ wag the stock ‘dog’ or allow for the options to become a significant portion of their wealth. Ideally, executives should consider the tax aspect, the outlook for the stock and their own situation such as risk profile and existing portfolio allocation.
The most important variables to consider are timing, taxes and the risk adjusted return potential of the stock. For example, should the ISO’s be exercised without selling the stock or should it be exercised and simultaneously sold? The former will likely trigger Alternative Minimum Taxes (AMT), for which executive will have to generate the required cash, but the executive will participate in any future stock appreciation. The latter, called ‘cashless exercise’, will generate the funds required for taxes from the sale of stock, however the executive will have to pay the much higher short-term capital gains tax and will not participate in future stock gains. AMT generated on exercise of ISOs is a ‘preference item’ there are strategies available either to minimize it by exercising early or managing other income such as generated by the exercise of NQSO.
There are also choices that the IRS offers which could change the situation. For example, in some cases exercising early (ie before the options have vested) can be an attractive option. In this case, holders need to file form 83(b) with the IRS to take advantage of lower potential taxes due to the early exercise. While this could potentially save a significant amount in taxes, the flipside is that the executive is exposed to the risk of losing the money spent on early exercise, if his company (Especially a start-up) fails or if his options are forfeited before vesting.
In addition to the above tax considerations, since these options can amount to a significant portion of overall compensation, holders should also plan for the expected cash outflow to pay taxes. Options have a limited life and if the price of the underlying stock fall below the strike price, it could expire worthless. There have been several cases of executives whose stock option grant grew significantly in value as the stock price rose but subsequently when the stock price crashed they were left with a tax liability that was more than the value of the stocks they received on exercise.
An adviser working with a tax consultant can help manage options grants with a holistic approach.
PLEASE NOTE: SARSI, LLC DOES NOT PROVIDE TAX ADVICE. THE ABOVE IS FOR INFORMATION PURPOSES ONLY. PLEASE CONSULT YOUR TAX ADVISER FOR HELP WITH YOUR TAX MANAGEMENT.