Weighing Your Options: Tax Planning for Incentive Stock Options

Stock options are a type of compensation that companies give to their employees. There are two main types of stock options: statutory and nonstatutory. Statutory options give special tax benefits to employees and don’t trigger income, but employers can’t deduct them. Nonstatutory options trigger income for employees and deductions for employers. Nonstatutory options are more common, but statutory options have become popular, especially for technology companies with high stock values. Statutory options include employee stock purchase plans and incentive stock options, which allow employees to share in the company’s stock appreciation. Employee stock purchase plans defer the appreciation until retirement, while incentive stock options allow employees to realize the appreciation while still working. However, employees with incentive stock options may have to pay a lot of taxes. Stock options are a type of employee benefit that allow you to buy company stock at a lower price. In order for stock options to be considered a special type called “ISOs”, there are certain rules that must be followed. For example, the options must be granted to employees, and they can’t last for more than 10 years. The price at which you can buy the stock must be at or higher than its current value. There’s also a limit on how much stock you can buy each year using the options. If you leave the company, you can’t keep the options, and you can only sell the stock after holding onto it for a certain amount of time. If you don’t follow these rules, the options are no longer considered special and are taxed differently. If you have ISOs (Incentive Stock Options), you won’t have to pay taxes right away when you exercise them. You only have to pay taxes when you sell the stock, and then it’s taxed like a capital gain. So, for example, if you bought stock for $5 a share, and then sold it for $145 a share, you’d pay taxes on the $140 profit. If you sell your stock from an employee stock option before waiting the required amount of time, you’ll be taxed as if it’s a regular stock option instead of a special tax-free one. This means you’ll be taxed on the difference between the price you paid for the stock and the price you sold it for. Most plans let you pay for the stock with cash or with other stock you already own. You can also do a “cashless exercise” where you use some of the stock you’re buying to pay for the purchase. If we ignore taxes for now, all three ways of paying for stock options end up giving the person the same amount of money.

For example, if someone has the option to buy stock at $5 each and they buy 1,000 shares when the stock is worth $100 each, they could pay $5,000 in cash, or they could use 50 shares of stock they already own, or they could do a cashless exercise. In each case, their total value goes up by $95,000. If you have stock options through your job, there are different tax implications depending on how you pay for the stock.

If you have an Incentive Stock Option (ISO) and you pay the strike price in cash, you won’t be taxed on the stock you acquire or the cash you paid. If you use previously owned shares to pay the strike price, you also won’t be taxed as long as those shares weren’t acquired through an ISO and were held for more than two years after you got them and one year after you used them to pay for the new shares.

For example, let’s say in 1998 you were granted an ISO with a $5 strike price. In 2000, you exercise the option and pay $5 per share for 1000 shares. You won’t be taxed on this and your basis for those shares is $5 each. Then in 2003, when the stock is worth $125 per share, you exercise with respect to an additional 4000 shares and use 160 of the shares you acquired in 2000 to pay the $20,000 strike price. The tax basis and holding period for the 160 remitted shares are transferred to the 160 acquired shares, and the rest of the acquired shares have a basis of zero.

So basically, if you pay for your stock options with cash or already owned shares, you might not have to pay taxes when you acquire the new shares. If you buy company stocks through your employee stock option and then use those stocks to pay for more stocks before you have held onto them for a year, you’ll have to pay taxes on the stocks you used to pay for the new ones. You’ll also have to pay taxes on any extra money you make when you sell those stocks. A cashless exercise of stock options is similar to selling some of the shares right away to cover the cost of buying them. This results in the option holder being taxed on the shares they sell, instead of the ones they keep. This can affect the tax advantages of the stock options. However, when considering the alternative minimum tax, these alternatives may not be as bad as they seem. When you exercise an ISO, you might not have to pay regular income tax, but you could still be subject to something called alternative minimum tax (AMT). This means that for AMT purposes, you have to include the difference between the stock’s fair market value at exercise and the strike price in the year the stock becomes freely transferable.

For example, if you have an ISO with a strike price of $5 and you exercise it when the stock’s fair market value is $100, you have to adjust your income by $950,000 for AMT purposes. This could lead to a higher tax liability. Keep in mind that if you exercise your ISO with respect to unvested shares, the AMT adjustment is not required until the shares vest. At that time, the AMT adjustment equals the difference between the stock’s fair market value at vesting (not exercise) and the strike price. So, if the stock value goes up between the time you exercise and the shares vest, you could still owe AMT on that increase in value. If you have stock options at work, you might have to pay something called alternative minimum tax (AMT) when you exercise them. This can be a big hassle because you need to have cash to pay the tax, and it’s hard to get a credit for it later. One way to avoid this is by selling some of the shares right after you exercise the options. By doing this, you can increase your regular income tax and decrease the AMT, so you don’t have to pay as much. For example, if you exercise options for 12,000 shares and the fair market value is $125, you can avoid the AMT by selling about 8,309 shares. This way, you won’t have to deal with the AMT at all. The optionee’s income tax liability is $487,207.68. The optionee’s tentative AMT liability is $487,200. If the stock’s value is much higher than the strike price, the optionee may need to sell some of the shares to avoid AMT liability. They should consider selling enough shares to have cash to pay taxes and the strike price. In this example, the optionee would need to sell about 4,378 shares to have enough cash. When you exercise an ISO and sell some of the stock, you have to pay income tax and might have to pay alternative minimum tax (AMT). The AMT doesn’t increase your basis in the stock, but you can get some of it back as a credit. This credit can be used in future years to reduce your income tax, but only if your income tax is higher than your AMT.

For example, let’s say you exercised an ISO and sold some of the stock, and then had to pay AMT. The AMT you paid can be used as a credit in future years. So, in the next year, when you sell more stock and make money, you can use the credit to reduce your income tax.

In simple terms, when you sell stock from exercising an ISO, you might have to pay AMT, but you can get some of it back as a credit to use against your income tax in the future. In 2001, the optionee’s income tax liability was $313,402 and their alternative minimum tax (AMT) liability was $122,110. The optionee was able to apply an AMT credit of $186,793 to reduce their income tax liability. This credit is often difficult to use and may remain unused for several years. Tax advisors should carefully consider the implications of exercising ISO stock options and the potential for incurring AMT liability. It’s important to consult with financial planners and securities experts to make informed decisions. This text discusses the tax code and regulations related to stock options. It mentions different sections of the tax code and how they apply to stock options, as well as the potential tax implications for option holders. It also includes information about the author and their background in tax law.

Source: https://www.floridabar.org/the-florida-bar-journal/weighing-your-options-tax-planning-for-incentive-stock-options/