Volume 18, Number 1
Exercising Stock Options
What You (and Your Clients) Need to Know Before Joining the Dot-Com World
By Robert W. Wood
A number of provisions in the Internal Revenue Code are of particular benefit to technology companies and their employees. Generally speaking, provisions that are specifically designed for technology (the research and development tax credit, for example, and provisions regarding capital gains on certain transfers of intellectual property) might be seen as solely applicable to technology companies. A number of other provisions in the Code, however, are not specifically designed for technology companies, but in practice seem largely to be used there.
The best example of the latter are the numerous (and somewhat complex) provisions governing stock options. Because of the prevalence of stock options in today’s world—and their enormous importance in most technology companies—this article focuses on those rules.
Nonqualified Stock Options
Nonqualified stock options (NSOs) are a catchall category. A company may grant employees an option to acquire stock on any terms, exercisable over any period of years. The option price may be above or below the fair market value of the stock on date of grant. There is great flexibility.
An employee is not taxed when an NSO is granted, as long as the option does not have a readily ascertainable fair market value. An option does not have a readily ascertainable fair market value unless it is actively traded on an established market, or the employee establishes that:
• The option is transferable;
• The option is exercisable in full by the employee;
• The option and the underlying stock are not subject to any restriction or condition (other than to secure payment of the purchase price) that has a significant effect upon the fair market value of the option; and
• The option has a readily ascertainable fair market value.
NSOs rarely meet these requirements. Thus, there generally is no tax to the employee on the date the NSO is granted.
So when is the NSO taxed? An employee recognizes ordinary income when the option is exercised in an amount equal to the difference between the fair market value of the shares and the option exercise price. The fair market value of the shares is determined without regard to restrictions on resale under the Securities Act of 1933 (such as the two-year holding period required for public resales of unregistered shares).
Remember, this is ordinary income on exercise of the NSO. An employee recognizes capital gain or loss when the option shares are later sold. The amount of gain or loss is equal to the difference between the sales price of the shares and the employee’s basis in the shares.
What about the employer? There are no tax consequences to the employee or employer when an option expires by its terms. However, the employee recognizes ordinary income (and wages) on amounts paid by the employer to cancel an option.
An employer is entitled to a deduction when the employee exercises the NSO. The amount of the deduction is equal to the ordinary income recognized by the employee. The employer is entitled to a deduction if it files a Form W-2 for the employee on a timely basis or otherwise proves that the employee included the option gain in gross income.
The employee must report the grant of an NSO on the tax return for the year in which the option was granted. There is no similar reporting requirement for the grant of an incentive stock option.
Incentive Stock Options
The other major type of stock option is the incentive stock option (ISO). There is often considerable confusion in the minds of employees as to whether they have received NSOs or ISOs. Incentive stock options are subject to a number of special rules. As will be seen below, however, if you qualify for these special rules there is a more favorable tax treatment.
An ISO must meet the following requirements:
1 . The option must be granted under a plan. The plan must set forth the aggregate number of shares that may be issued as option shares (specific number or formula).
2. The plan must specify the employees or class of employees eligible. For example, the plan may specify that all employees or only key employees of the company are eligible to receive options.
3. The plan must be approved by shareholders within 12 months before or after the date the plan is adopted. The approval by shareholders must comply with the corporate charter, bylaws, and applicable state laws concerning shareholder approval for issuance of corporate stock or options. If there is no applicable state law, the plan must be approved (a) by a majority of votes cast at a shareholders’ meeting at which a majority quorum is present in person or by proxy, or (b) by a method that is treated as adequate under applicable state law.
4 . The options must be granted within ten years from the earlier of the date the plan is adopted by the board of directors or approved by the shareholders.
5 . The option must be exercisable within ten years from the date the option is granted. In the case of 10 percent shareholders, the option must be exercisable within five years from the date of grant.
6 . The option price must not be less than the fair market value of the stock on the date the option is granted. This requirement will be met if there is a good faith effort to value the stock accurately, even if the option price is less than the fair market value when the option is granted.
7. The option must not be transferable by the employee except on death, and is exercisable during the lifetime of the employee only by the employee. However, the employee may transfer the option to a revocable trust for estate planning purposes.
8 . The employee must not own 10 percent or more of the company’s voting stock at the time the option is granted. However, this requirement does not apply if the option price is at least 110 percent of the fair market value of the shares subject to the option, and the option is exercisable within five years from the date of grant.
9 . $100,000 cap. The aggregate fair market value of stock (determined at the time the option is granted) for which ISOs are exercisable for the first time by the employee during any calendar year may not exceed $100,000. Options granted in excess of the $100,000 limit are treated as NSOs.
The option may contain any other provision not inconsistent with the above requirements. Such provisions in-clude the right of the employer to repurchase the shares at fair market value at termination of service, or a right of first refusal to purchase the share in the event of a proposed sale.
An option that otherwise qualifies as an ISO may be treated as a nonqualified option if the company designates the option as an NSO at the time the option is granted. A company can also designate what portion of the option will be treated as an NSO.
An ISO may not be granted in tandem with another option. Under these arrangements, the exercise of one option affects the right to exercise the other option. Tandem stock options are not permitted because they may be used to evade the qualification requirements under section 422 of the Code. However, ISOs may be granted in tandem with stock appreciation rights.
Advantages of ISOs versus NSOs
As the above list makes clear, there are a number of hurdles to be navigated before stock options can qualify as incentive stock options. If the ISO requirements are met, there is an important difference in tax treatment. There is no tax to the employee when the company grants an ISO, because the exercise price must be at least equal to fair market value of the stock at the time of grant.
Plus, there is no regular income tax to the employee on exercise of an ISO, provided certain requirements are met. The employee must remain an employee of the company at all times from the date of grant until three months prior to the date of exercise. Thus, the employee must exercise the option during employment or within three months after termination. If the employee becomes disabled, he or she may exercise the option for up to one year after disability.
Watch out for AMT. The employee may be subject to the alternative minimum tax (AMT) on exercise of an ISO. The AMT does not apply if the shares are sold in a disqualifying disposition in the same taxable year that the option is exercised. The AMT does apply on exercise if the shares are sold in a disqualifying disposition in a subsequent calendar year, although the offsetting credit for the AMT paid in the year of exercise would apply against the regular tax in the year of sale and subsequent years.
Example: Jones has $100,000 of taxable income in 2000. In 1988, his employer granted him an ISO to acquire 20,000 shares of stock for $10 per share. Jones exercises the option in 2000 when the fair market value of the shares is $20 per share. Jones sells the shares in 2001 for $30 a share. The tax for 2000 is computed as follows:
• Taxable income: $100,000
• Tax rate (using single individual tax rate for 1998 of 36% on taxable income from $115,001 to $250,000): x 36%
• Regular tax: $36,000
Planning note: To avoid the AMT, the employee should (a) avoid exercising ISOs in a year in which he or she is subject to the AMT, or (b) make a disqualifying disposition in the same year the options are exercised.
Sale of ISO Shares
The employee recognizes gain or loss and/or compensation income when the shares are sold. The amount of gain or loss and compensation income depends upon whether the shares are sold in a qualifying or nonqualifying sale.
An employee recognizes long-term capital gain (or loss) if the shares are sold in a qualifying sale. The amount of the gain is the difference between the sales price and the exercise price. A qualifying sale is a sale made at least two years after the date of grant and one year after the shares are transferred to the employee.
An employee recognizes compensation income and capital gain or loss if he or she makes a disqualifying sale. A disqualifying sale is a sale made within two years from the date of grant, or within one year after the shares are transferred to the employee. The spread on exercise is compensation income. The balance of the gain is long- or short-term capital gain depending on the holding period. If the shares decline in value after the date of exercise, the compensation income is limited to the difference between the sales price and the amount paid for the shares. The tax is imposed in the year the disqualifying sale is made.
Example: An employee is granted an ISO on January 1, 1999, at $100 per share (the fair market value at that time). The employee exercises the option on January 1, 2000, when the value of the shares is $200 per share. The employee sells the shares for $250 on June 1, 2000, in disqualifying disposition. The employee recognizes compensation income of $100 in 2000 (difference between fair market value of shares on the date of exercise and amount paid). The balance of the gain is long-term capital gain because the employee held the shares for more than one year. The long-term capital gain is $50 (difference between sales price of $250 and employee’s basis in shares of $200).
No withholding is required for income recognized on a disqualifying disposition. There is no alternative minimum tax if the employee makes a disqualifying disposition in the same year that the option is exercised.
The ISO has an advantage for the employee even if he or she fails to satisfy the holding period requirements because the employee can postpone the tax until the date of sale, when the employee receives money to pay the taxes owed. The modification, extension, or renewal of an ISO is treated as the grant of a new option. There are no tax consequences to the employee or employer when an ISO expires by its terms.
Deduction by employer. An employer is not entitled to a deduction when the option is granted or exercised. The employer is not entitled to a deduction if the employee sells the shares in a qualifying disposition (sale more than two years after the date of grant and one year after the date of purchase).
The employer is entitled to a deduction if the employee sells the shares in a disqualifying disposition. The amount of the deduction is equal to the ordinary income recognized by the employee. However, the employer is not entitled to a deduction unless it files a Form W-2 or W-2c with the employee and the federal government before the date that the employer files its tax return claiming a deduction. Alternatively, the employer may take a deduction if it proves that the employee included the option income in gross income.
Reporting requirements. The em-ployer must provide an information statement to employees by January 31 following the year in which the option is exercised. The information statement must set forth the date the option was granted, the date the shares were transferred, the fair market value of the option shares, the option price, and various other information.
Pyramiding and stock-for-stock exercises. A number of mechanical issues can arise with stock options. Very frequently, the employees of the technology company will need guidance about how they can exercise. Some employees may not have enough cash to pay the purchase price of the shares on exercise of an option. A plan may permit the employee to pay for the option shares by delivering to the company shares already owned by the employee equal in value to the option exercise price.
The employee can go one step further by using shares acquired upon exercise to acquire additional option shares. This is sometimes called pyramiding, because the employee can start with a few shares and exchange them for an ever-increasing amount until all of the options have been exercised.
Example: Ed has an option to acquire 100 shares of stock for $5 per share. He decides to exercise the option when the fair market value of each share is $10. Ed purchases one share for $5. That share valued at $10 is then used to acquire two additional shares with an option price of $5 each. The two new shares valued at $20 are then traded in for four shares valued at $40, which are traded in for eight shares valued at $80, etc. At the end of the pyramid scheme, Ed owns shares having a value equal to the option spread on the date of exercise plus the cash paid for the first purchase.
The IRS permits pyramiding with mere bookkeeping entries so that the parties can avoid the back-and-forth delivery of stock certificates.
Stock-for-stock exercises of nonqualified stock options. An employee is taxed only on the value of additional shares acquired under a nonqualified stock option plan in a stock-for-stock exchange, representing the spread between the fair market value of the shares acquired and the option exercise price.
The IRS treats the exercise as two transactions. First, there is a tax-free exchange of old shares for new shares under I.R.C. § 1036, to the extent that the employee receives shares in the exchange equal to the number of shares given to the company. The new shares retain the basis and holding period of the old shares. Second, to the extent that the employee receives more shares from the company than he or she gives up, the employee has taxable compensation equal to the value of the additional shares. The basis in the additional shares received equals the amount of cash tendered, if any, plus ordinary income recognized on the exchange. Usually, the additional shares have a basis equal to the option spread because this is the amount taxed as ordinary income on exercise.
Example: Sally has a nonqualified option to buy ten shares at $5 per share. She exercises the option by delivering to the company two shares she already owns that have a fair market value of $25. Two of the new shares received are treated as part of a like-kind exchange, with a basis and holding period equal to that of the two old shares. The value of the eight additional shares received is taxable compensation under I.R.C. § 83. The holding period for these shares commences on date of exercise. The basis is equal to the ordinary income recognized (i.e., the value of the eight shares on the date of exercise).
This approach permits an employee to exercise an option without having to borrow money or sell stock and recognize capital gain.
Stock-for-stock exercises of incentive stock options. An employee may purchase stock on exercise of an ISO with other stock of the company that he or she already owns. Again, the IRS treats the exercise as two transactions. First, there is a tax-free exchange of old shares for new shares, to the extent that the employee receives shares in the exchange equal to the number of shares given to the company. The new shares retain the same basis and holding period of the old shares. Second, the additional shares received (representing the option spread) have a zero basis and a new holding period commencing on the date of the exchange. There is no tax as a result of the exchange except for the alternative minimum tax. Gain on the subsequent sale of the shares is taxed as ordinary income or capital gain (depending on the holding period).
There is an exception to these rules. An employee will recognize income immediately if the exchange results in a disqualifying disposition. The following rules apply in determining whether there is a disqualifying disposition:
1. There is no disqualifying disposition if the employee uses incentive shares that have been held for the requisite holding period under I.R.C. § 422(a)(1).
2. There is no disqualifying disposition if the employee uses incentive shares that have not been held for the requisite holding period to exercise a nonqualified stock option. The new shares received under the nonqualified stock option plan are treated as incentive shares with the same basis and holding period as the incentive shares given up. The nonqualified shares received in excess of the incentive shares given up in the exchange are taxed immediately.
3. There is a disqualifying disposition if the employee uses incentive shares that have not been held for the requisite holding period to exercise an incentive stock option. This rule was designed to prevent pyramiding in connection with the exercise of an incentive stock option.
Cashless exercises. There are a number of ways that an employee can exercise options without raising funds to pay the exercise price and withholding taxes. An option plan may permit cashless exercises in one of the following ways:
• The option may be granted in tandem with stock appreciation rights (SARs). SARs give employees the right to receive cash equal to the difference between the fair market value of the stock and the option exercise price. The option is canceled on exercise of the related SAR.
• The employer may give employees alternative methods of paying for the exercise price, such as loans or cash bonuses.
• The plan may permit employees to pay the option exercise price with stock already owned by them. This is called pyramiding if the employee uses shares acquired upon exercise of an option immediately to acquire additional shares.
• The employer may withhold part of the shares that would otherwise be transferred to the employee upon exercise of the option in payment of the option price and withholding taxes.
• The employee may simultaneously exercise the option and sell the option stock, usually through a broker.
Robert W. Wood practices law with Robert W. Wood, P.C., in San Francisco. Admitted to the bars of California, New York, Arizona, Wyoming, Montana, and the District of Columbia, and qualified as a solicitor in England and Wales, he is a Certified Specialist in Taxation, and is the author of 25 books. His most recent book is Taxation of Damage Awards and Settlement Payments , 2d ed. (1998), published by Tax Institute (e-mail firstname.lastname@example.org ).