ISOs and AMT traps.

While stock options have been an integral part of executive compensation packages since the 1980s, they have never been as widely used or contained as many features as they do today. Increasingly, companies are implementing broad-based programs in which all (or most) employees, not just a handful of executives, are granted stock options. This trend, combined with unprecedented growth in the stock market during recent years, has caused stock options to represent a substantial portion of the compensation and net worth of many executives.

Although academicians and other professionals recommend that employees hold their options as long as possible, a 1996 study by two professors at Duke University and the University of North Carolina at Chapel Hill found that two-thirds of lower-level employees and one-third of senior executives exercise their options within six months of the options being vested and "in the money." The study also found that 90% of employees receiving stock options sold their stock immediately after they exercised their options. This would seem to suggest that employees either do not understand stock options or are otherwise unable to effectively maximize their value.

The development and implementation of an effective option strategy requires the optionee to make decisions not only as to when to exercise the stock options, but also as to how to exercise them. Companies usually provide several alternative means by which employees can exercise their stock options. The simplest form is for the employee to pay cash or write a check. Many employees, particularly nonmanagement employees, however, do not have the financial means to cover the cost of exercising their options. Therefore, many companies have established "cashless exercise" programs with brokerage firms, in which a broker briefly lends money to an employee to allow him to exercise the options. The broker then immediately sells the stock, repays the loan and provides the difference between the exercise price and the grant price (for a nonqualified stock option (NQSO), less amounts withheld for taxes) to the employee. Finally, some companies permit their employees to pay for option stock with previously owned shares of employer stock. Although the decisions as to when and how to exercise stock options are primarily investment decisions, proper tax planning, especially for incentive stock options (ISOs) and the myriad of alternative minimum tax (AMT) issues they create, is essential.

ISOs

The tax treatment of an option's exercise generally depends on whether the option is an NQSO or an ISO. An ISO is an option:

1. That is granted to an individual, for any reason connected with employment, by the employer corporation (or its parent or subsidiary), to buy stock of the employer corporation (or its parent or subsidiary);

2. That satisfies the ISO qualification requirements; and

3. Whose terms do not provide that the option is not to be treated as an ISO.

If an option does not qualify for treatment as a statutory option under Sec. 421, it is subject to the NQSO rules.

Taxation of ISOs

The taxation of ISOs is governed by Secs. 421 and 422, which generally provide that neither the receipt nor the exercise of an ISO has current tax consequences to the optionee; however, the optionee generally must include an AMT adjustment equal to the compensation income that would have been recognized had the option been treated as an NQSO.

Dual-Basis Assets

The difference in treatment of ISOs for regular and AMT purposes causes ISO stock to be a dual-basis asset; it has a different basis for regular tax and AMT purposes, regardless of whether the AMT adjustment from the exercise of an ISO caused the optionee to pay AMT. Subsequently, when the optionee sells the stock, the difference between the regular tax gain or loss and the AMT gain or loss is reported as an adjustment. Because the AMT basis is usually higher than the regular tax basis, the adjustment is usually favorable.

AMT Capital Loss Limitation

For regular tax purposes, under Sec. 1211(b), the amount of net capital losses a taxpayer may offset against ordinary income is limited to $3,000 ($1,500 for married taxpayers filing separate returns). Although the Code does not expressly state that the capital loss limitation is to apply for AMT purposes, it is clear from the Tax Reform Act of 1986 (TRA '86) Committee Reports that Congress intended such limitation to apply. If option stock has depreciated between the exercise and the disposition dates, a failure to calculate and apply the AMT capital loss limitation may result in an incorrect determination of alternative minimum taxable income (AMTI).

Example 1: On Jan. 1, 1999, A exercised 1000 ISOs with a strike price of $10 per share. The fair market value (FMV) of the stock on that date was $25 per share. For 1999, A reports an AMT adjustment of $15,000 (1,000 shares x ($25 - $10)). On April 15, 2000, A sells the 100 shares of option stock for $15 per share. For regular tax purposes, A has realized a $5,000 gain on the sale (1,000 shares x ($15 - $10)). For AMT purposes, A has realized a $10,000 loss (1,000 shares x ($15 - $25)); however, his AMT deductible capital loss is limited to $3,000. Thus, although the total difference between his regular tax gain of $5,000 and his realized AMT loss of $10,000 is $15,000, the adjustment is limited to $8,000. Thus, A would have a $7,000 AMT capital loss carryforward.

In addition to the capital loss limitation, optionees and their tax preparers should also consider the application of the wash sale rules.

Disqualifying Dispositions

To qualify for favorable tax treatment, stock received from the exercise of an ISO must be held for one year after the date of exercise, or, if later, two years from the date of grant. If the stock is disposed of during the prohibited period, the disposition will cause the optionee to recognize ordinary income, equal to the bargain element at the exercise date. However, if the stock depreciates between the exercise and the disposition dates, the amount of ordinary income is limited to the excess of the proceeds from the disqualifying disposition over the amount paid to exercise the option. To the extent the proceeds of the disqualifying disposition exceed the stock's FMV on the exercise date, the excess will be treated as a capital gain, generally short-term.

Income Tax Withholding, FICA and FUTA

Although the amount of compensation income caused by the exercise of an NQSO and a disqualified disposition of ISO stock generally is the same, the Service currently does not require withholding on the income from the disqualifying disposition. In addition, the income from the disqualified disposition of ISO stock is not subject to FICA or FUTA taxes; see Rev. Rul. 71-52. In Notice 97-49, the Service announced that it was reconsidering its position in this area, although no action has been taken to date. This discrepancy may offer some savings to an optionee who desires cash and has the choice between exercising an ISO and an NQSO.

AMT Consequences of Disqualifying Dispositions

If a disqualifying disposition occurs in the same year the option was initially exercised, an AMT adjustment is not necessary. In this case, the AMT rules coordinate the amount of income from a disqualifying disposition for AMT purposes with the amount included in income for regular tax purposes. This coordination does not occur if the disqualifying disposition occurs in a later year.

Although neither the Code nor the regulations contains illustrations of the appropriate AMT treatment when a disqualifying disposition occurs in a later year, in such a case, the compensation income reported in the year of the disqualifying disposition is not income for AMT purposes. Thus, presumably, the optionee would have a favorable AMT adjustment equal to the compensation included in regular taxable income as a result of the disqualifying disposition.

If a disqualifying disposition were likely, it would be advisable for it to occur in the year of exercise. This strategy will prevent the optionee from incurring AMT on the exercise. Although optionees who incur AMT generally are entitled to a minimum tax credit, not all optionees will be able to use their AMT credit carryover in the year of the disqualifying disposition.

Identification of Shares

Many corporate executives who receive stock options have a significant holding in employer stock. In addition to holding shares purchased on the open market in arm's-length transactions, they may hold shares from numerous forms of equity compensation bestowed on them by their employers (i.e., restricted stock grants, employee stock purchase plans, ISO and NQSO grants). Further, assuming the executive has been accumulating shares over time, it is not uncommon to own shares with drastically different bases. Due to these differences, executives should be extremely careful to properly identify the shares to be sold.

Identification must occur at the time the shares are sold. If the executive does not identify the shares to be sold, the basis will be determined using the FIFO method. Although the average-basis rules may be used for mutual fund shares, they are not available for individual stocks. An executive can identify shares for a current sale, even if he failed to identify shares of the same stock in the past.

If a stockholder holds certificates for his shares, identification is generally accomplished by delivering the certificate that represents the shares the stockholder wishes to sell. If a stockholder does not hold the shares in certificate form or if the certificate to be delivered contains shares with different bases, the stockholder must specify to the broker the shares to be sold. In addition, the stockholder must receive written confirmation of that specification from the broker within a reasonable time.

In identifying the shares to be sold, the optionee should consider not only the shares' regular tax basis, but also their AMT basis. In addition, for ISO stock, the optionee should determine whether the shares have satisfied the ISO holding period.

Using Previously Acquired Employer Stock to Exercise Options

It has become common for companies to permit option holders to use shares of previously acquired employer stock to pay when exercising a new option. These transactions are commonly referred to as "stock swaps" and can be used to exercise both ISOs and NQSOs. When a stock swap occurs, gain or loss generally is not recognized on the payment shares, and the basis of the exchange shares is the same as the basis of the payment shares. The ability to defer gain recognition on the payment shares is the primary advantage of the swap technique.

Example 2: Employee J has an option to purchase 100 shares of stock for $10 per share. The stock's current FMV is $25 per share. In lieu of using cash to exercise the option, J can use $1,000 of previously acquired employer stock. J would turn in 40 shares ($1,000/$25 per share) as payment shares and would receive 40 exchange shares and 60 incremental shares, for a total of 100 shares.

The shares surrendered to pay for the option are referred to as "payment shares." In addition, the number of option shares received from the exercise equal to the number of the payment shares are referred to as "exchange shares" and the number of shares received from the option exercise as "incremental shares."

Exercising ISOs Using a Stock Swap

Although previously acquired employer stock (other than immature ISO stock) may be used to exercise an ISO, following the swap transaction, both the exchange shares and the incremental shares will be subject to the special ISO holding period. When using a stock swap to exercise an ISO, the basis of the exchange shares generally would equal the basis of the payment shares, and the basis of the incremental shares generally will be zero. Except when determining if a disqualifying disposition has occured, the holding period of the exchange shares will include the holding period of the payment shares. The holding period of the incremental shares will begin on the swap date.

Example J: On June 1, 1999, X Corporation grants an ISO to employee A, entitling him to purchase 100 shams of X common stock at $10 per share. On June 1, 2000, when the FMV of X stock is $25 per sham, A exercises the option and 100 shares are transferred to him on that date. To exercise the option, A transferred to X 40 shares of X common stock that he had purchased on the open market on June 1, 1999 for $5 per share. After exercising the option, A owns 100 shams of ISO stock, as follows:

           Regular
          tax basis
Shares   (per share)     Holding period

  40         $5         Began June 1, 1999
  60         $0         Began June 1, 2000

While the Code permits shareholders to specifically identify the shares to be sold, when an ISO is exercised via a stock swap and a partial disqualifying disposition occurs for the stock so acquired, the proposed regulations require the disposition of the shares with the lowest basis.

Example 4: Using the same basic facts as in Example 3, A sold 75 of the 100 shares in a disqualifying disposition on Sept. 1,2001 for $30 per share. Applying the special identification rule of the proposed regulations, he would be deemed to have disposed of all 60 of the incremental shares (which had a zero basis) and 15 of the exchange shares. A's tax consequences would be summarized as follows:

Shares   Proceeds   Basis   Total "gain"   Compensation

  60     $1,800      $0       $1,800         $1,500
  15       $450     $75         $375             $0

Shares   Capital gain

  60      $300 (S/T)
  15      $375 (L/T)

The compensation income represents the excess of the ISO stock's FMV on the exercise date over the option price, and the capital gain represents the appreciation in the ISO stock that occurred after the exercise date.

Using Immature ISO Shares as Exchange Shares

Immature ISO stock may be used as exchange shares to exercise a NQSO; however, it is important to note that, following the transaction, the exchange shares must be held for the duration of the ISO holding period. If, however, immature ISO shares are used as exchange shares to exercise an ISO, the exchange will not qualify for nonrecognition treatment ("anti-pyramiding" rule). If an optionee makes a disqualifying disposition of immature ISO stock by using it to exercise another ISO, the optionee must include in income the compensation element created by the transaction.

If the immature ISO stock has appreciated between the exercise date and the swap date, the treatment of the capital gain portion of the gain is somewhat unclear. Although Sec. 424(c)(3) states that the nonrecognition rule of Sec. I036(b) does not apply to the transaction, Prop. Regs. Sec. 1.422A-2(i)(4), Example 3, and Letter Ruling 9629028 indicate that any appreciation in the stock's value after the exercise date that is not taxed as compensation income under the disqualified disposition rules is subject to the Sec. 1036 nonrecognition rules.

Example 5: On June 1,1999, X Corporation grants an ISO to employee A, entitling him to purchase 100 shares of X common stock at $10 per share. The option provides that A can exercise the option with previously acquired X common stock. On June 1, 2000, when the FMV of X common stock is $25 per share, A exercises the option and 100 shares are transferred to him on that date. To exercise the option, A transferred to X 40 shares of X common stock that he had purchased on the open market on June 1,1997 for $5 per share.

On Sept. 1, 2000, A uses 75 shares of the ISO stock to exercise a second ISO. X granted this to A on Jan. 1, 2000, entitling him to purchase 100 shares of X common stock at $22.50 per share. As in Example 4, A has made a disqualifying disposition of the 75 shares and A must recognize the amount of compensation attributable to his exercise of the first option of $1,500. After the exercise of the second option, A owns a total of 125 shares of ISO stock, as follows:

            Regular
Shares    tax basis         Holding period

  25           5        Began June 1, 1997
  15           5        Began June 1, 1997
  60          25        Began June 1, 1999
  25           0        Beginning Sept. 1, 2000

Unlike Example 4, A does not recognize capital gain as a result of exercising the second option, because, for all purposes other than determining whether the exercise is a disposition under Sec. 425(c), such exercise is an exhange to which Sec. 1036 applies.

Although not addressed in the following examples, the optionee would need to perform a separate set of calculations to determine the appropriate basis of the shares for AMT purposes.

Early Exercise Options

The majority of options issued to employees generally are not exercisable until vested. Recently, however, companies (in particular, pre-IPO companies) have begun granting options exercisable in exchange for nonvested stock.

Neither the exercise of an early exercise option, nor the later vesting of the option stock, will have regular tax consequences; however, the vesting of the option stock would create an AMT adjustment equal to the excess (if any) of the option stock's FMV at the time of vesting over the amount paid to exercise the option. Thus, the optionee should consider whether to make a Sec. 83(b) election exclusively for AMT purposes.

As with any Sec. 83(b) election, there is a risk that the option property ultimately may not vest in the optionee. In the case of a forfeiture, the optionee would not be entitled to claim an AMT adjustment for the amount included in AMTI as a result of the Sec. 83(b) election, although he would be entitled to claim a capital loss deduction for the option price.

Conclusion

Understanding the tax consequences of stock options is essential to maximizing the after-tax value of an optionee's stock option portfolio. In working with the optionee to develop an effective stock option plan, tax and other financial advisers should carefully review option agreements to identify the features of the options. They should also maintain an inventory of the optionee's outstanding options, as well as his holdings of company stock.

FROM NATALIE L. BELL, COHEN & COMPANY, LLC, CLEVELAND, OH

Editor: Anthony Bakale, CPA, MT Cohen & Company, CPAs Summit International Associates, Inc. Cleveland, OH