There is nothing basic about incentive stock options. Incentive stock options have built-in complexity that goes far beyond their restricted stock and non-qualified stock option cousins. The holding requirements for qualified dispositions and alternative minimum taxes are two complexities that quickly come to mind.
If you find yourself on the receiving end of incentive stock options, you have a potentially great opportunity. Therefore, it’s prudent to evaluate the opportunity at hand, regardless of the learning curve.
Below is an introduction of several key terms, such as grant and vesting dates, and a further discussion of cash vs. cashless exercise, as well as the impact of bargain elements and AMT.
Vesting Date/Expiration Date/Grant Price
Incentive stock options are issued with a grant date. The grant date is the date at which the employee is given the shares. The grant date is also the date at which the shares are valued. This grant price is the price at which an employee can buy the shares of stock. The grant date is not necessarily the time when the employees can act on their option to buy the shares.
The next question is when, namely when can an employee act on the opportunity to buy the shares. This answer to this question is simple – when the stock options vest.
Upon issue, stock options are given a vesting schedule. A vesting schedule is a period of time that must pass before the employee can act upon (i.e. buy) the shares. Once the shares vest, the employee has the right to buy the shares at the grant price.
A third key date for incentive stock options is the expiration date. The expiration date is the final day that the employee can buy the shares at the grant price. Should this date pass and the shares go unexercised, they vanish.
Exercising your Shares – Cash vs. Cashless Exercise
When an employee exercises incentive stock options, they will need to buy the shares they are exercising. The price for these shares is the number of shares times the stock option price.
For example, if an employee has 1,000 shares at a grant price of $20 per share, the employee will need to pay $20,000 (20 multiplied by 1,000).
Fortunately, there are two options to pay the required $20,000 – a cash exercise or a cashless exercise.
With a cash exercise, the person exercising the stock options pays cash for the shares. Simply put, they write a check to cover the cost.
For those who don’t have the cash (or simply don’t want to exercise in this way), a cashless exercise may be an alternative option.
In a cashless exercise, the person holding the stock options will simultaneously exercise and sell the shares to cover the cash needed to buy the shares.
Continuing with the example above, let’s assume that an employee has 1,000 shares at a grant price of $20 per share. Let’s further assume that the current market price of the stock is $80 per share.
Assuming these hypothetical values, the stock options have an in-the-money value of $60 per share, totaling $60,000.
Now let’s think about this from a practical sense. Would you be willing to pay $20,000 for something that was immediately worth $80,000? Of course you would!
But what if you didn’t have the $20,000 cash on hand to pay for it?
Enter the cashless exercise.
In a cashless exercise, the option holder will immediately exercise and sell a portion of the vested shares that covers their cash need. In this example, the calculation is 333.33 shares.
After completing a cashless exercise, the option holder will be left holding 666.67 shares (1,000 minus the number of shares they had to sell to cover the cash need).
The AMT Hit – More Cash Required
When you exercise incentive stock options, it’s possible that you will be subject to AMT (alternative minimum tax). AMT is a tax calculation run concurrently with your normal taxes. More often than not, you don’t realize this because you are not impacted. Unfortunately, exercising incentive stock options could make someone subject to AMT.
Specifically, the bargain element of exercised incentive stock options is included as an AMT adjustment. The bargain element is equal to the difference between the grant price and the value of the shares on the date of exercise.
Continuing with our example above, the difference between a $20 per share grant price and an $80 per share value on the date of exercise is the “bargain element.” In this scenario, $60,000 ($60 per share times 1,000 shares) will be included as an AMT preference item when calculating your income taxes.
(Note: the IRS normally taxes realized income. The bargain element of incentive stock options and its impact on AMT may force you to pay taxes on yet-to-be-realized income.)
When exercising incentive stock options, it’s important to consider how taxes and a cash exercise may impact your nest egg.
If an option holder chooses a cash exercise, they will have an out-of-pocket cash call. As we mentioned above, a cash exercise requires the option holder to pay with personal assets.
In addition, the employee exercising incentive stock options may be required to pay AMT – a second cash call. In the year of exercise, the combination of two cash calls may be too much to overcome, forcing a cashless exercise.
Ordinary Income vs. Capital Gain
As you can see (if you’ve made it this far), even the basics of incentive stock options can leave one’s head spinning. So why go through all this mess?
Simply put, the answer is taxes.
The gain on incentive stock options, if exercised following the rules for qualified dispositions, may receive favorable capital asset tax treatment (compared to ordinary income).
Again with the example above, let’s compare a 33% ordinary income tax rate to a preferential 15% long-term capital gains tax rate.
Assuming the same $60,000, we see the following:
|Ordinary Income||Capital Gains|
|Total Proceeds (1000 shares)||$80,000||$80,000|
|Total Gain (1000 shares)||$60,000||$60,000|
|Taxed as ordinary income (33%)||$18,000|
|Taxed as capital gains (15%)||$9,000|
As you can see, the net proceeds from this transaction clearly work in favor of the capital gains tax, as illustrated through a qualified disposition.
To be fair, a full analysis will consider the taxes that were “pre-paid”, as detailed above, via the AMT tax. The scope of this tax analysis is beyond the basics, but it’s prudent to acknowledge that this will change the numbers.
The AMT Credit
As discussed above, it’s possible that an employee who has exercised incentive stock options has pre-paid AMT. Assuming that this is true, there is the possibility of re-capturing some or all of this pre-paid tax as a credit on future tax returns.
Often, the largest AMT hit occurs in years where the bargain element is the largest (the difference between the grant price and the exercise price). Therefore, it makes sense that the opportunity to recapture AMT exists when selling these same shares as qualified disposition. Following this thought pattern, it may make sense to sell the tranche of exercised stock options with the largest bargain element.
The Basics aren’t so Basic
As you can see, there is nothing basic about incentive stock options. As you move into a world that should coordinate stock option holding periods, AMT, taxes, and concentrated positions, you enter a world that goes well beyond the basics.
On the other hand, incentive stock options can be basic if they’re simply treated as compensation and sold as a nonqualified disposition. Following this logic, all stock option gains (if any) are taxed as ordinary income. However, this may not be in the best interest of the option holder.
Consequently, it makes sense to consult with an expert who has experience working with ISOs and the potential opportunities and pitfalls for your specific case. It’s worth a second set of eyes to be sure that you’re crossing your Ts and dotting your Is in the best possible way.
Tax services are not offered through, or supervised by Lincoln Investment, or Capital Analysts. None of the information in this document should be considered as tax advice.
The examples above are for illustrative purposes only and do not attempt to predict actual results of any particular investment.