Employee stock options are contracts giving employees the right to buy the company’s common stock at a specified exercise price after a specified vesting period (e.g., two to four years). The exercise price is typically the market price of the stock when the option is granted (although it can be higher or lower), and the option is usually exercisable for a certain period (e.g., five or ten years). When the exercise price of the stock is less than the stock’s fair market value (FMV), the option is said to be “in the money” and worth exercising. When the exercise price of the stock is more than the stock’s FMV, the option is said to be “out of the money” and not worth exercising.
Here are year-end strategies that holders of employee stock options should consider in light of current Congressional efforts at tax simplification and tax rate reduction, which, if enacted, would most likely be in effect for 2018.
Incentive stock options (ISOs). An ISO, which is a form of qualified stock option, is granted to an employee by an employer to buy stock or ownership interests in the employer. There are no regular income tax consequences when an ISO is granted or exercised; the employee has capital gain if the stock is sold at a gain.
An ISO must meet various requirements. For example, the option price must be no less than the market value of the stock at the time of the grant, it must be exercised within ten years from the time of grant, and the market value of the stock for any ISOs exercisable in any year is limited to $100,000 for any individual.
To qualify for favorable treatment, stock acquired through the exercise of an ISO generally can’t be disposed of within two years after the option is granted or one year after the stock is transferred to the employee. Also, for the entire time from the date an ISO is granted until three months (one year in case of an employee with a total and permanent disability) before its exercise, the option holder must be an employee of the option grantor (or its parent or subsidiary or certain successor corporations).
An employee who meets the dual holding periods won’t recognize income as a result of exercising the ISO. If, after holding the stock for more than one year, he or she sells at a gain the stock acquired by exercising the ISO, all of the gain will be favorably-taxed capital gain. But, under current law, the gain also would be subject to the 3.8% medicare surtax.
If there is a disqualifying disposition of a share of stock, Code Sec. 421 does not apply to the transfer of the shares. Instead, the exercise of the option is governed by Code Sec. 83 and its regs. Thus, in the tax year in which the disqualifying disposition occurs, the individual recognizes ordinary compensation income (and gets a basis increase) equal to the bargain element—that is, the FMV of the stock on the date the stock is transferred less the exercise price (determined without reduction for any brokerage fees or other disposition costs). If the disqualifying disposition would trigger an allowable loss (e.g., not a sale to a related taxpayer), then the amount includible in the employee’s income as a result of that disqualifying disposition can’t be more than the amount realized on the sale, minus the employee’s adjusted basis in the stock.
For AMT purposes, when an ISO is exercised, if the stock is “substantially vested” on the exercise date (the typical case), the amount of the bargain element generally is included in alternative minimum taxable income (AMTI) for the year in which the exercise occurs as an adjustment under Code Sec. 56(b)(3). (If the stock is not substantially vested in the year of exercise, income is includible under the Code Sec. 83 rules for AMT purposes when the stock becomes substantially vested.) In future years, a tax credit may be allowed against regular tax for AMT paid on account of the adjustment for ISO exercises.
Illustration In January of 2014, Michael, an employee of XYZ, was granted an ISO allowing him to buy 4,000 shares of XYZ at $50 per share. In December of 2017, he exercises the option when the stock is valued at $75 per share. For regular income tax purposes, Michael doesn’t recognize income when he exercises the ISO in 2017. However, for that year, Michael must recognize AMTI of $100,000 (4,000 × $25 ($75 – $50)) due to the option exercise. When Michael sells the XYZ shares, his per-share AMT basis will reflect an increase for the amount of the AMTI that was recognized in 2017 when the ISO was exercised.
Recommendation: The Republican plan for tax reform has called for the AMT to be repealed. Taxpayers who believe the plan will be adopted and will go into effect for 2018 would be wise to hold off exercising ISOs they hold until next year if they would be exposed to the AMT in 2017.
Observation: Some taxpayers who hold “in the money” ISOs plan to sell the underlying stock immediately after the option exercise, even though the disposition will be a disqualifying one resulting in ordinary income. In this case, there will be no AMT adjustment or extra AMT liability. Here, too, holding off on the exercise of ISOs until next year would be beneficial if the ordinary income on the disposition of the underlying stock would be taxed at a lower rate next year than this year. Of course, waiting in the hope that taxes will be lower next year must be weighed against the possibility that the underlying stock will decline in value.
Nonqualified stock options (NSOs). NSOs, so-called because they don’t meet the tax law’s rules for qualified options, are taxed to the employee under the general Code Sec. 83 rules governing the transfer of property other than money in return for services. Under these rules, the option recipient is treated as receiving compensation income equal to the FMV of the option (less any amount paid for it) when an unrestricted right to the stock is received and the FMV of that right can be reasonably ascertained. Stock options without a “readily ascertainable market value” are specifically excepted by Code Sec. 83(e)(3).
In the case of NSOs, options that are not tradeable (as is usually the case with such options) have no “readily ascertainable market value”, and Code Sec. 83 applies to the stock received upon exercise of the options rather than at the time of option receipt. The taxable amount would be the bargain element, that is, the difference between the stock’s market price on the date of option exercise, less the exercise price under the option.
Recommendation: A taxpayer holding “in the money” NSOs should consider deferring their exercise until 2018 if the taxpayer believes that tax reform will be enacted this year and result in lower tax rates next year. However, market conditions must be considered—the stock could increase in value thereby increasing the tax cost of the option exercise.
Recommendation: NSO holders may want to consider exercising their options this year, rather than waiting till next, if the bargain element currently is small, but they believe that the underlying stock could dramatically increase in value in coming years. The small bargain element will be taxed as ordinary income in 2017, but the anticipated appreciation in the stock, if it materializes, would be favorably taxed long-term capital gain.
For more information on tax issues, contact Larson & Company today.