Stock Options

Matt Grodin CPA

2

Definitions

• Incentive Stock Option (ISO)– Most tax advantaged option, but also the most complicated. You will likely pay Alternative Minimum Tax (AMT) on exercise, but you can get a credit for this if you hold long-term. Also – there’s no withholding. In the end, you can qualify for long term treatment on the exercise AND sale.

• Nonqualified Stock Option (NSO) – When you exercise, you purchase it cheaply, and the discount is treated like compensation income. Tax is withheld at 25% federal, and state withholding. Note – this may not be the actual tax due. You can then decide whether to hold the stock for long term treatment or not from the point of exercise.

• Restricted Stock Units (RSU) – Similar to NSO, but the stock vests, there is no need to purchase it at exercise

3

Incentive Stock Options

Grant Exercise Sell

Pri

ce

Date

Grant: no tax effect

Exercise: Potential AMT on price difference between FMV at exercise and exercise price. This AMT will be a credit in the (possibly distant) future.

Sell: Regular tax purposes: Capital gain on difference between sale price and exercise price. If in AMT: capital gain on difference between sale price and FMV at exercise

Long term rates IF exercise 1 year after grant and sell 2 years after grant

Sell in same day/same year – on W-2 like comp, but no tax withheld.

Potential strategy: Sell enough to cover AMT, hold on to rest for long term capital gains.

Exercise early to lock in low cost basis. If basis isn’t low – hold onto the option to reduce risk.

FMV

Exercise

price

4

NSO – Cashless exercise

Grant Exercise and Sell

Pri

ce

Date

Grant: no tax effect

Exercise and sell: : Receive your cash.

Some of the cash will he held to pay for the purchase, and some (typically 25% Federal, 10% state) will be held for taxes – also showing up in your W2.

Recognize ordinary income on the bargain difference between FMV and Exercise price.

(It should show up in Your W2.)

FMV

Exercise Price

Vesting

5

NSO Timing

Grant Exercise Sell

Pri

ce

Date

Grant: no tax effect

Exercise: Purchase the stock at a discounted price.

Recognize ordinary income on the bargain difference between FMV and Exercise price. (It should

show up in Your W2.)

Sell: Capital gain (or loss) on difference between FMV and Purchase price

Long term rates IF held for more than one year after exercise.

Potential strategy: At exercise, immediately sell enough to come up with cash to purchase all of your options.

If stock is not transferrable at the time of exercise, an 83(b) election will accelerate income recognition

and start the clock on capital gains.

Exercise early to lock in low cost basis. If basis isn’t low – hold onto the option to reduce risk.

FMV

Exercise Price

Cost basis

Vesting

6

RSU

Grant Sell

Pri

ce

Date

Grant: no tax effect

Vesting: Ordinary income in your W2

Tax withheld typically at 25% federal 10% state which may or may not be right

Sell: Capital gain on difference between FMV and Purchase price

FMV

Cost basis

Vesting

7

ISO going down?

Grant Exercise Sell

Pri

ce

Date

Grant: no tax effect

Exercise: Potential AMT on price difference between FMV at exercise and grant price. This AMT will be a credit in the (possibly distant) future. No special AMT consequence if sold in year of exercise

Sell: Regular tax purposes: Capital loss on difference between sale price and exercise price AMT purposes: capital loss on difference between sale price and FMV at exercise

Long term rates IF exercise 1 year after grant and sell 2 years after grant

FMV

Exercise

price

8

83(b) Election – starting the clock

If there are restrictions on stock when exercised, income will not be recognized until the restrictions are removed. An 83(b) election has several effects:

• Starts the clock on capital gains at the date of exercise even if restrictions are in place.

• Makes the stock holder recognize income at the date of exercise, potentially resulting in less income to recognize.

Option holders may be able to exercise unvested stock. If this is the case, income will not be immediately recognized unless an 83(b) election is made.

9

When to Exercise and hold vs Same day sale ISO

Exercise and Hold

Your regular income tax rates are substantially higher than long term capital gain rates ( 33%+) 225k+ before options

Exercise price is relatively low compared to FMV at date of exercise

You are prepared for the AMT

Same day sale

Relatively low regular income tax rates.

Need cash this year

Reduce risk, diversify, opportunity cost