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How and when you exercise options can have big tax consequences.Stock
options have become an important part of employee compensation packages. Employers view
options as an effective means of attracting, retaining, and motivating employees, and
employees enjoy the opportunity to participate in the appreciation of their
employers’ stock price. To maximize the benefits of options, employers and employees
need to understand how different types of options are taxed and the methods for funding
the exercise.
Basic Terms: Options are the right to purchase shares of common stock
at a stated price during a specific period of time. In most cases, options are granted
with an exercise price equal to the fair market value (FMV) of the stock at the date of
grant. If the stock price rises above the exercise price, the option can be used to
purchase stock at the lower (exercise) price. The difference between the FMV of the stock
at the exercise date and the exercise price is the option’s bargain element. Most
employee stock options vest (become exercisable) at a date after the date of grant.
Unexercised options expire after a period of time, as prescribed in the stock option plan.
Types of Stock Options: There are two types of stock options commonly
used in employee compensation -- nonqualified stock options (NQSOs) and incentive stock
options (ISOs). The tax treatment differs substantially for each type.
- Nonqualified Stock Options: NQSOs are the most popular type of options
offered today. The recipient employee does not pay income tax when the NQSOs are granted
(except in rare cases). When the options are exercised, the bargain element is taxed as
ordinary income to the employee (this is true even if the employee has given away the
NQSOs, for example, to a trust for his/her children). The FMV at the date of exercise is
the recipient’s basis in the stock. If the stock price goes up after the options are
exercised and the stock is later sold, this increase is a capital gain. The holding period
for a capital gain is measured from the date of exercise (not the date the options were
granted).
When NQSOs are exercised, the issuing company must withhold social security taxes, federal
income taxes, and possibly state taxes on the bargain element. The company records an
increase in salary expense for tax purposes (a deductible expense) equal to the bargain
element.
- Incentive Stock Options: From the recipient’s viewpoint, ISOs may
offer greater income tax benefits (although, unlike NQSOs, ISOs cannot be gifted). The
employee does not recognize income on the grant of ISOs (as with NQSOs) and he/she does
not recognize income on the exercise of ISOs (unlike NQSOs) -- the bargain element in an
ISO is an addition to alternative minimum taxable income in the year the option is
exercised. When the stock is sold, the difference between the sale price and the exercise
price is a capital gain, provided certain holding period requirements are met. Stock
acquired under an ISO must be held for at least one year after the exercise date, and two
years after the grant date. If ISO stock is sold before the end of the minimum holding
period, the recipient has a disqualifying distribution -- ordinary income tax rates apply
to the bargain element in disqualifying distributions. Like stock acquired through NQSOs,
the capital gain holding period is measured from the date of exercise.
There is some controversy as to whether the issuing company is required to withhold
social security taxes, federal income taxes, and state income taxes (if applicable) upon
exercise of an ISO or a disqualifying distribution. The issuing company does not receive a
tax deduction when ISOs are exercised (except in the case of disqualifying distributions).
ISO treatment is limited to exercisable options of $100,000 (FMV on date of grant) per
year -- options that become exercisable for more than $100,000 FMV in any year will be
considered NQSOs.
The following chart summarizes tax consequences for NQSOs and ISOs:
| Event |
Nonqualified Stock Options |
Incentive Stock Option |
| Grant of option |
No tax, unless option is publicly traded and meets other
conditions. |
No tax. |
| Exercise of option |
Bargain element taxed as ordinary compensation income
using regular tax rates. |
No tax, although bargain element increases alternative
minimum taxable income. |
| Sale of stock acquired by exercising option |
Capital gain or loss on sale price less basis (FMV at
exercise date). |
Capital gain or loss on the difference between the sale
price and exercise price. |
| Disqualifying distribution |
Not applicable. |
Bargain element taxed as ordinary compensation income
using regular tax rates. |
Financing the Exercise: When options are exercised, the employee (or
other holder) must pay the employer the exercise price. If the employee does not have
sufficient funds to cover the exercise price, several alternatives are available:
- Sell Stock: Raise funds by selling stock from an existing portfolio
(may result in taxable gain or loss on securities sold).
- Swap Company Stock: Exchange issuing company stock already owned (using
current FMV) for the exercise price.
- Cashless Exercise: Pay exercise price on options by simultaneously
exercising options, selling a portion of the shares issued on exercise, and paying the
exercise price with the proceeds. Additional shares are sold to satisfy tax withholdings.
- Stock Pyramiding: Pay cash to exercise a few options, then redeem the
option shares in order to exercise more options, repeating this process until all the
options are exercised.
- Margin Loans: Obtain a margin loan on an existing investment portfolio
from your broker. Individual investors can generally borrow up to 50 percent of the FMV of
their portfolio, and interest expense on a margin loan is tax deductible.
Other Considerations: Recipients of stock options should evaluate the
impact of a resignation, retirement, or death on options that have not been exercised.
These are some thoughts to consider about stock options. Your Deloitte
& Touche financial advisor also can provide information and should be consulted
before any action is taken.
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