Tax Tip for April 2001
Incentive stock options (ISOs)
This
month’s Tax Tip expands on last month’s Stock Option discussion to address
Incentive stock options (ISO) in more detail. For the purposes of this
discussion, let’s assume the ISO gives you the right to buy 1,000 shares of
the company's stock at its fair market value at the time of the ISO's grant
(expected to be about $100 per share) for a five-year period following the
grant.
The
grant of the ISO to you will not be taxable. Nor will your later exercise of the
ISO (except that it may make you subject to the alternative minimum tax, see
below). For example, if the market value of the stock goes to $150 per share and
you exercise the option and buy the 1,000 shares with a market value of $150,000
for the $100,000 option price, you won't be subject to regular income tax on
your $50,000 bargain purchase. You also won't be subject to social security and
Medicare (FICA) tax at the time of exercise, although IRS may change this rule
after 2002.
If
you later sell the stock, say when its value reaches $200 per share, for
$200,000, your $100,000 profit will be taxed as a capital gain in the year of
sale. Although the sale is taxable, no tax will be withheld from your paycheck.
IRS may change the rule on withholding after 2002.
If
you want to qualify for the favorable tax treatment available with an ISO (so
the $100,000 employment-related profit is taxed at capital gain rates rather
than at the higher ordinary income tax rates imposed on regular compensation),
you cannot make a “disposition” of the stock: (1) within two years after the
ISO is granted, or (2) within one year after the stock has been transferred to
you. A “disposition” includes a sale, exchange, gift, or similar lifetime
transfer of legal title.
If
you dispose of the stock before both of the required holding periods have
expired, you will be taxed as if you had received compensation in the disposal
year. You will have to treat the gain on that premature disposition as ordinary
income to the extent of the lesser of: (1) the fair market value of the stock on
the date of exercise minus the option price, or (2) the amount realized on the
disposition minus the option price.
For
example, assume again that you buy $150,000 worth of your company's stock for
$100,000 by exercising the ISO and later sell this stock for $200,000. The
spread between the value on the date of exercise ($150,000) minus the option
price ($100,000) would be $50,000. The difference between the amount realized on
the disposition of the stock ($200,000) minus the option price ($100,000) would
be $100,000. Consequently, your $100,000 gain on the premature disposition would
be ordinary income to the extent of $50,000 (the lesser of $50,000 or $100,000).
If
you receive less on the premature disposition than the value when you exercised
the ISO (and the disposition wasn't a sale to a related taxpayer), then the
taxable amount is limited to the amount you realized on the sale minus your
adjusted basis in the stock. For example, if you sold the stock for $130,000,
then you would have $30,000 of compensation income ($130,000 amount realized
less $100,000 adjusted basis).
Although
your ISO has a five-year exercise period, the tax rules that apply to ISOs
require that you exercise the option no later than three months after you
terminate your employment. There are some exceptions to this employment
requirement if the termination involves a transfer to a related company (e.g., a
parent or subsidiary).
The
special tax treatment allowed to taxpayers for regular tax purposes when an ISO
is exercised (i.e., no taxation at the time the ISO is exercised, deferral of
tax of the benefit associated with the ISO until disposition of the stock, and
taxation of the entire profit on the sale of stock acquired through ISO exercise
at capital gain rates if ISO holding periods are met) isn't allowed for
alternative minimum tax (AMT) purposes. Under the AMT rules, you must include
the value of the stock you acquire through an ISO exercise (reduced by the
option price you paid) in your alternative minimum taxable income in the year
the stock becomes freely transferable or isn't subject to a substantial risk of
forfeiture. For most taxpayers, this occurs in the year the ISO is exercised.
This means that even though you aren't taxed for regular tax purposes, you may
have still have to pay alternative minimum tax on the value of the stock (minus
what you paid for it) when you exercise the ISO even though you don't sell the
stock and even if the stock price declines significantly after you exercise the
ISO. Under these circumstances, the tax benefits of your ISO will clearly be
diminished.
As
you can see, these technically complex incentive stock option rules require
careful tax planning strategies. If you would like to discuss any of these
matters in more detail, please call.
