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Chapter 27: Stock option planning.

WHAT IS IT?

Stock options are typically given to executives of publicly traded companies as an award for past performance or an incentive for future results. But they are also commonly granted to non-executive employees and used as incentive tools by larger non-publicly traded businesses as well.

A stock option is a right to purchase one share of stock at a specified price. Usually, stock options can be converted to stock only after a specified period of time has elapsed. Then, the exercise of the option must occur before the expiration of period of time specified in the option.

There are a number of key terms that need to be defined before the discussion about how stock options are taxed can begin:

Grant--The transfer of the stock option by the company to the option holder. The date on which the employee receives the option is called the "grant date."

Strike Price--Also referred to as the "exercise price" or "option price," this is the predetermined price at which the option can be converted to stock.

Exercise--The transaction that converts the stock option into stock. The date on which the transaction occurs is known as the "exercise date."

Spread--The difference between the fair market value of the stock and the strike price of the stock option on the date of exercise. The spread also represents the potential compensation element of stock options that could be subject to taxation. The spread is sometimes referred to as the "bargain element."

Vesting--Some stock options may not be exercised immediately upon grant. Instead, the absolute and unconditional right to exercise the options may accrue or "vest" over a specified period of time. It is not uncommon, for example, for stock options to vest in equal amounts over four years. In that case, 25% of the stock options would become exercisable on each anniversary of the grant.

Vested--Refers to stock options that are currently exercisable.

In-the-money--Stock options with a strike price that is less than the current fair market value of the stock. If the reverse is true, an option is said to be "out-of-the-money" or "underwater."

For tax purposes, stock options are divided into two possible types. The type of stock option is determined as of the grant date and controls how the options will be taxed upon their exercise.

Incentive Stock Options (ISOs)--Also referred to as statutory stock options, ISOs are covered by IRC Section 422. There are a number of stringent rules that must be adhered to, both by the company granting the options and the employee who receives the options. In general, the taxation of ISOs is deferred until the employee actually sells the stock. At that time, the employee is taxable at long-term capital gain rates on the difference between the selling price and the exercise price. But there are rules for alternative minimum tax ("AMT") purposes that could cause an acceleration, or pre-payment, of tax in the year of exercise.

Nonqualified stock options (NQSOs)--Although the rules surrounding NQSOs are much less stringent than ISOs, taxation of these options occurs as of the exercise date. The spread between the exercise price and the stock price on the exercise date is taxed as additional compensation, subject to the taxpayer's ordinary income tax rate.

NONQUALIFIED STOCK OPTIONS

NQSOs are options that do not meet the requirements of Code Section 422, either intentionally or otherwise. There are generally no tax implications to the recipient of an NQSO on the grant date. The only exception is for publicly traded stock options. But it is extremely rare to find nonqualified employee stock options that trade in the public market. Note that employee stock options are different than puts and calls that commonly trade on publicly held companies.

NQSOs are a convenient and flexible way to award or encourage employees. There are no limits as to how many NQSOs may be granted, how the exercise price is determined, or the time limitation for expiration of the option. In fact, NQSOs are sometimes granted at an exercise price that is less than the fair market value of the stock on the grant date. These are referred to as "discounted stock options." But the deferred compensation rules of IRC Section 409A enacted under the American Jobs Creation Act of 2004 may cause such discounted stock options to be subject to tax upon grant (see further discussion of IRC Section 409A below).

The taxation of NQSOs typically occurs on the exercise date. At that point, the difference between the fair market value of the stock and the exercise price is recognized as additional compensation unless the stock is restricted (i.e. the stock is subject to a substantial risk of forfeiture and is not transferable). Payroll taxes must be withheld upon the exercise of NQSOs (federal, state, and local withholding, FICA, and FUTA). The spread is also included on the employee's Form W-2 wages in the year of exercise.

Employers benefit in two ways from the exercise of NQSOs. First, the company receives the gross exercise cost of the options. Second, the company is entitled to a tax deduction for the compensation element that is taxed to the employee.

Example: Balloons, Inc., Drew Freeney's employer, granted Drew an NQSO for 1,000 shares of stock of Balloons, Inc. The NQSO was exercisable immediately but was not publicly traded. The exercise price was $20 per share. When the stock hit $50 per share, Drew exercised the NQSO for all of the stock by paying Balloons, Inc. $20,000 (1,000 shares at $20 per share). As a result, he will recognize $30,000 of compensation (1,000 shares at $50 per share less his exercise cost of $20,000). Balloons, Inc. will report this $30,000 of compensation one Drew's Form W-2 for the year of exercise and will also claim a tax deduction for the same amount in the year of exercise. In addition, Drew must pay Balloons an amount sufficient to cover any required employee payroll taxes.

If, at the time a NQSO is exercised, the stock is deemed to be restricted, the taxation of the stock may be deferred until the restrictions lapse. As covered more fully in Chapter 25, Conversion of Income, if the stock is subject to a substantial risk of forfeiture and is not freely transferable by the employee, the stock is considered to be restricted stock.

Example: Using the same facts in the previous example, assume the stock option plan for Balloons, Inc. states that, although the NQSOs may be exercised at any time after grant, the stock will be forfeited if the employee leaves within five years of the date of grant and the stock is not transferable during that time. In that case, the taxation of the stock (and the company's deduction) would not occur until the restrictions lapse. On the fifth anniversary, if the stock is valued at $70 per share, Drew would be forced to recognize $50,000 of compensation income at that time ([$70-$20] x 1,000). Drew's holding period for capital gain purposes begins on the date the restrictions lapse.

The employee does have the option to make a so called "Section 83(b) election." This would subject the stock to taxation at the time of exercise but enable the gain from that point to be capital gain. The mechanics of making Section 83(b) elections is covered in Chapter 25 Conversion of Income.

Example: Continuing with the same fact pattern, Drew feels very optimistic about both the growth potential of the stock and that he will be able to meet the terms of the restrictions. So he decides to make an 83(b) election despite the fact that the restrictions will not lapse for some time. The resulting compensation at the time of exercise will be subject to tax as a result of the 83(b) election. The holding period for the stock begins at the date of exercise, so all future appreciation will qualify for capital gain treatment once the stock becomes transferable.

Strategies for Exercising Nonqualified Stock Options

Exercising nonqualified stock options generates taxable income to the extent of the difference between (a) the stock's fair market value and (b) the exercise cost. Therefore, it is equivalent to the employee receiving a cash bonus from the company and then the employee immediately using the bonus to purchase company stock. From this point, the taxpayer can opt to sell the stock or hold onto the resulting shares.

There are four common methods of funding the exercise cost of NQSOs:

1. The employee pays the exercise cost and holds the stock. If the employee believes that the stock has the potential to rise in the future, exercising NQSOs and holding the stock will begin the clock for long-term capital gain treatment. The exercise cost and resulting payroll taxes would need to be paid by the employee. The employee uses her own cash or other investments to pay the exercise price.

2. Funds are borrowed to exercise NQSOs. Borrowing money to cover the exercise cost and related payroll taxes may be a sound way to convert options to stock. The interest paid on such a loan will usually qualify as an investment interest expense that is potentially deductible by the employee.

3. "Cashless" exercise. NQSOs may be exercised and immediately sold for the fair market value of the stock. If the employee sells all of the stock, the exercise is the equivalent of a cash bonus. But in a sense, it is better than a real cash bonus since the timing of the taxable event is within the employee's control. A cashless exercise also occurs in situations where the employee sells only a sufficient number of shares to cover the exercise cost and the required payroll taxes.

Example: Mary Marsh exercises 1,000 NQSOs with an exercise cost of $10 per share at a time when the stock is trading at $40 per share. As a result, Mary will recognize $30,000 of taxable income ([$40-$10] x 1,000). In order to cover the exercise cost, Mary immediately sells 250 shares ($40 x 250 = $10,000). She may also decide to sell extra shares to cover the payroll taxes on the $30,000 of taxable income.

Note that since options are exercised at an average fair market value, a cashless exercise may create a gain or loss since the sale of the stock would occur on the open market at the prevailing stock price.

4. Exchanging existing shares to exercise NQSOs. Instead of coming up with cash or borrowing funds to exercise NQSOs that the employee wishes to hold, existing shares of the company stock may be exchanged to cover the exercise cost and related payroll taxes. The exchange of existing shares for new shares in the same company is not taxable under IRC Section 1036.

Example: John Simms owns 100 shares of Palmer Corp. with a basis of $10 per share. He decides to exercise 500 NQSOs he received from Palmer with an exercise cost of $20 per share. At the time of the exercise, the stock is trading at $100. Since the value of his existing shares equals his exercise cost of the NQSOs ($10,000), he uses the existing shares to fund this cost. John will report compensation of $40,000 ([$100-$20] x 500). Ignoring the payroll tax cost, which John will need to pay from separate funds, John will have 500 shares of Palmer Corp. 100 of these shares will continue to have a cost of $10 per share--representing a carryover of the basis and holding period of the shares that were exchanged and not taxed. The remaining 400 shares will have a cost basis of $40,000, the taxable income recognized on the exercise of the 500 NQSOs.

INCENTIVE STOCK OPTIONS

A stock option can qualify as an ISO only if all of the requirements of IRC Section 422 are satisfied. As a general rule, the employee will not recognize any taxable income upon the grant or the exercise of an ISO. Instead, taxation will occur upon the ultimate sale of the stock acquired through the exercise of the ISO. So the timing of the taxable event is within the control of the employee. At that point, the resulting gain is normally taxed as a long-term capital gain.

Although no taxable income is recognized at the exercise of an ISO, the spread does create an adjustment item for alternative minimum tax (AMT) purposes. Since the AMT is often an unexpected (and costly) result of exercising ISOs, proper planning must be done to determine the amount and timing of ISO exercises.

There are six requirements for an option to qualify as an ISO:

1. Option plan must be approved by shareholders. The stock option must be granted as part of a plan approved by the shareholders of the company. The number of shares available under the option plan and the eligible employees must be identified. (1)

2. Expiration of options. The options must be granted within 10 years of the earlier of shareholder approval or adoption and exercised within 10 years of the grant date. (2)

3. Exercise price. The exercise price of the option must equal or exceed the fair market value of the stock on the grant date. (3)

4. Restrictions on transferability. The options may not be transferred except upon the death of the employee. The employee can be the only eligible person to exercise an ISO. (4)

5. Shareholder restrictions. If an employee owns more than 10% of the company at the time the option is granted, the option price must be at least 110% of the stock's fair market value and the option must be exercised within five years of the grant date. (5)

6. Limitation on grant. The fair market value of the stock that can be obtained through the exercise of ISOs is limited to $100,000 per calendar year. The fair market value is determined as of the grant date. The applicable year is determined by the year in which the ISO is first exercisable. Any ISOs granted that exceed this limit are treated as NQSOs. (6) Note that this limitation is determined as of the grant date. It makes no difference when the options are ultimately exercised.

Example: Jones, Inc. grants Ted Johnson 10,000 ISOs with an exercise price of $50 per share. One-quarter of the ISOs vest over each of the next four years. Therefore, 2,500 ISOs with a total fair market value of $125,000 would be exercisable for the first time in each of the next four years. Only 2,000 of the options would qualify as ISOs (2,000 x $50 = $100,000). The remaining 500 options would be treated as NQSOs.

As previously mentioned, there is generally no income to be recognized by an employee upon the exercise of an ISO. (7) The exercise price of the ISO becomes the employee's basis in the stock and the holding period begins upon the exercise. Upon the sale of the stock in a "qualifying disposition," the taxpayer recognizes a long-term capital gain which is taxed at the more favorable capital gain rates. Unlike the rules for NQSOs, the issuing company does not receive a compensation deduction upon the exercise or ultimate sale of ISO stock in a qualifying disposition.

A qualifying disposition is one that occurs more than two years from the date of grant and more than one year from the date of exercise. In addition, the employee must have been continuously employed by the company that granted the ISO from the grant date up to three months before the exercise date (except in the case of death or disability). (8) Exchanges, gifts, and transfers of legal title are all considered dispositions for the purpose of this rule.

Example: Andy Williams is granted 1,000 ISOs on March 15, 2008. He exercises the options on July 6, 2009. He must hold the ISO stock until July 7, 2010 in order to sell the shares in a qualifying disposition.

Any disposition that is not a qualifying disposition is automatically considered to be a disqualifying disposition. If a disqualifying disposition of stock acquired by the exercise of an ISO occurs, the gain from the disposition is determined as follows:

1. Capital gain is recognized to the extent the selling price exceeds the fair market value on the date of exercise.

2. Ordinary income (treated as compensation) is recognized to the extent of the difference between the fair market value on the exercise date and the exercise cost. If the fair market value on the disposition date is less than the fair market value on the exercise date, the ordinary income is limited to the gain on the sale of the stock.

3. A capital loss is recognized only if the selling price is less than the exercise cost.

If a disqualifying disposition occurs, the ISO is essentially treated like a NQSO and the corporation would be entitled to a deduction for the ordinary income recognized by the employee. (9) Federal payroll taxes (FICA, FUTA, and federal income tax withholding) are not assessed on disqualifying dispositions. (10)

ISOs and the AMT

Although there is no income to be reported as a result of an exercise of ISOs for regular tax purposes, there are potential AMT implications. Generally, the spread that would be reported as compensation if the ISO were a NQSO is an addition to the employee's AMT income in the year of exercise. (11)

Since the spread is reported as income for AMT purposes, the employee has two different tax bases--one for regular taxes (equal to the exercise cost) and one for AMT (equal to the fair market value on the exercise date).

Example: Maria Shaunessy exercised 100 ISOs at a total cost of $5,000 in July. On the exercise date, the stock price was $75 per share. The total value of $7,500 ($75 x 100) less the exercise cost of $5,000 represents the spread that must be added to Maria's AMT income ($2,500). Maria's regular cost basis is the $5,000 exercise cost and her AMT cost basis is the $7,500 fair market value on the exercise date.

If the stock acquired through an ISO exercise is sold in a disqualifying disposition in the same year, no AMT adjustment is reported. (12)

Example: Using the same facts from the previous example, if Maria sells the stock for $8,500 in November of the same year, she would recognize a gain of $3,500. Of this amount $2,500 would be ordinary income ($7,500-$5,000) and $1,000 would be a short-term capital gain. No AMT adjustment would be required.

Since the regular tax basis and AMT basis are different, the sale of stock acquired through ISOs in any other year represents an adjusted gain or loss for AMT purposes in the future year.

Example: Instead of selling the stock in November, Maria waits until January of the following year. The AMT adjustment of $2,500 would be reported in the year of exercise. In the year the ISO stock is sold, she would adjust her AMT income down by the $2,500 difference in the tax basis of the stock.

Warning: The $3,000 capital loss rules apply for AMT as well as for regular tax purposes. If the stock price declined from the date of the ISO exercise, it is possible that the amount of the negative adjustment will be limited to account for the $3,000 capital loss limitation.

Example: Jack Brown exercised 5,000 ISOs when the stock was trading at $100 per share. His total exercise cost was $10,000 and he reported a positive AMT adjustment of $490,000 and paid a large amount of AMT as a result. The stock price tumbled and Jack sold the stock in a qualifying disposition when it was trading at $40 per share. For regular tax purposes, Jack recognizes a long-term capital gain of $190,000

([$40 x 5,000] - $10,000). For AMT purposes, Jack recognized a loss of $300,000 ($500,000 - $200,000). Since he has no other capital gains, his AMT loss is limited to $3,000. He will report an adjusted gain or loss of a negative $193,000 and carryover an AMT capital loss of $297,000 to future years.

Because of the potential AMT due in the year of exercise, combined with the capital loss limitations in future years, it may be wise to sell ISO stock that has declined since the exercise date in a disqualifying disposition in the same year as the year of exercise. It was not uncommon during the stock market's "Internet Bubble" to have an employee's AMT liability exceed the value of the stock when the tax was due. By selling stock in a disqualifying disposition, no AMT adjustment would need to be reported and the AMT can be minimized, if not eliminated. The net proceeds would then be used to pay the ordinary income tax due upon the disqualifying disposition.

The AMT adjustment created by the exercise of ISOs is a deferral item. As a result, any AMT that is paid may be recovered through the minimum tax credit ("MTC"). To the extent the AMT was generated by deferral items, a MTC is created. The MTC may generally be used in future years to offset a regular tax liability that exceeds the taxpayer's tentative minimum tax.

AMT paid as a result of ISO exercises is generally a prepayment of tax due to this MTC and will be recovered when the ISO stock is sold or as time passes and the MTC is utilized. The MTC is covered more fully in Chapter 18, Alternative Minimum Tax. As a result of the Emergency Economic Stabilization Act of 2008, more taxpayers who pay AMT as a result of exercising ISOs will be able to recover their MTC sooner due to the enactment of a more liberal policy for recovering the MTC. In addition, this law also waived unpaid tax liabilities relating to the exercise of ISOs attributable to tax years ending before January 1, 2008.

Strategies for exercising Incentive Stock Options

The interplay of the AMT, MTC, and regular tax implications creates the need for long-term multi-year planning to determine the most tax efficient way to exercise ISOs. Of course the fluctuation in the stock price makes obtaining absolute tax efficiency impossible.

In addition to the strategies outlined earlier in this chapter for funding the exercise of NQSOs, which also apply to ISOs, the following are ISO strategies which should be considered:

Staggering ISO exercises. Many employees wait to exercise their ISOs until the expiration date is approaching under the assumption that they are deferring taxes. But it may be wise to exercise a certain number of ISOs each year to reduce the overall AMT impact.

Since the AMT is usually less the regular tax liability for most taxpayers, there is a certain amount of ISO "spread" that can be absorbed each year without the imposition of the AMT. As a result, the employee (1) obtains ISO stock without paying any additional tax and (2) starts the clock running on the holding period needed for a qualifying disposition. After ISO stock is held for the requisite amount of time, the sale creates a negative adjustment, which then creates more room for additional ISOs to be exercised in the later years.

Example: Howard Washington projects that he is able to absorb $25,000 worth of AMT adjustments from the exercise of ISOs. He exercises 1,000 ISOs with cost of $10 per share when the stock price is $35 per share. He reports the $25,000 adjustment but pays no AMT. Howard projects in the next year that he once again is able to absorb $25,000 of AMT adjustments. He also decides to sell the stock he acquired from the ISO exercise in the prior year (more than one year from the exercise date and two years from the grant date). The negative AMT adjustment of $25,000 will allow him to absorb a larger amount of positive AMT adjustments from current year ISO exercises. Note that due to capital gains tax rate differences, the amount that can be absorbed may be less than $50,000, the otherwise available AMT adjustment room and the negative AMT adjustment created by the sale.

Planning for restricted stock. If the stock that is acquired by an ISO is restricted, the AMT adjustment is not reported until the year in which the restrictions lapse. If the stock price rises between the exercise date and when the restrictions lapse, a larger AMT adjustment must be reported at that time.

As is the case for restricted stock acquired by the exercise of NQSOs, the employee has the option to make a Section 83(b) election at the time of exercise. The AMT adjustment would then be locked in based on the fair market value on the exercise date. The mechanics of making Section 83(b) elections is covered in Chapter 25, Conversion of Income.

Use of leverage to buy dividend paying stocks. Until ISOs are exercised and converted to stock, the employee has no right to any dividends. With the tax rate on dividends currently at 15%, it may make sense to exercise ISOs sooner, even if a loan were necessary to support the exercise cost.

Example: Six years ago, Nina Walsh was granted 10,000 ISOs with an exercise cost of $5 per share. The stock is now trading at $30 per share and pays an annual dividend of $1 per share. In order to exercise the ISOs, she would need to pay $50,000 (assume that she does not pay any AMT as a result of this exercise). Using an interest rate of 8%, her total interest on the loan would be $4,000 per year. The interest could be fully deductible against ordinary income as investment interest expense depending on Nina's investment income and other itemized deductions. Assuming her marginal tax bracket is 35% and the interest can be fully deducted, her total interest cost is $2,600, after taxes. Since she now owns the stock, she will receive $10,000 per year of dividends. With a tax rate of 15% on dividends, she will net $8,500 of dividend income, after taxes. As a result of this strategy, she is ahead $5,900 per year after taxes.

Exchanging stock for stock. A common practice is to use existing ISO stock to exercise more ISOs. Since ISO stock usually has an unrealized gain associated with the shares, this stock would achieve the maximum gain deferral. In order for the technique to work, the ISO stock that is being exchanged must have been held for the requisite amount of time to avoid the disqualifying disposition rules.

As mentioned earlier for the NQSO strategies, the number of shares used in the exchange retain the basis (for regular and AMT purposes) and holding period they had before the exchange. The additional shares acquired would have a regular tax cost equal to amount of funds needed for the ISO exercise in excess of the value of the shares used in the exchange. The AMT basis for the new shares would be the fair market value of the new shares plus any additional amounts needed to fund the exercise cost.

Example: Mike Simms owns 100 shares of Palmer Corp. (acquired by ISO) with a regular tax basis of $10 per share and an AMT basis of $40 per share. He decides to exercise 500 ISOs he received from Palmer with an exercise cost of $20 per share. At the time of the exercise, the stock is trading at $100. Since the value of his existing shares equals his exercise cost of the ISOs ($10,000), he uses the existing shares to fund this cost. John will report an AMT adjustment of $40,000 ([$100--$20] x 500). John will then have 500 shares of Palmer Corp. 100 of these shares will continue to have a cost of $10 per share for regular tax purposes and $40 per share for AMT purposes--representing a carryover of the basis and holding period of the shares that were exchanged and not taxed. The remaining 400 shares will have a cost basis of zero (John paid nothing for them) and an AMT basis of $40,000, the total fair market value of the additional shares acquired by the ISO exercise.

QUESTIONS AND ANSWERS

Question--How are commissions and fees incurred upon the sale of stock acquired by an option exercise treated?

Answer--Commissions and fees are added to the cost of the stock acquired. Therefore, even in the case of an option exercise and immediate sale of the stock, the employee may report a small capital loss as a result of these expenses.

Question--Do the states follow the federal rules for ISOs?

Answer--Certain states follow the federal rules and others do not. The laws of state of residency and the state in which the options were earned (if different) should be reviewed to determine how the options are treated. States which do not follow the federal ISO rules typically treat the options as NQSOs and subject them to tax in the year of exercise.

Question--How do the deferred compensation rules of IRC Section 409A apply to typical stock option plans?

Answer--IRC Section 409A was structured to tax certain plans that provide for the deferral of compensation into future years unless certain requirements were met. The requirements centered on the timing of the elections by the employee to defer compensation, how the deferred compensation plan was funded, and the ultimate distribution options to the employee.

NQSO plans are not subject to the 409A rules if the terms of the plan meet certain safe harbor guidelines as contained in the final 409A regulations:

1. The exercise price must not be less that the value of the stock on the date of the grant and the number of shares must be fixed on the original date of the grant.

2. The stock received on exercise is subject to tax under IRC Section 83.

3. The option does not include any feature for the deferral of compensation other than the deferral of income until the later of (a) the date of exercise or the disposition of the option or (b) the time the stock first becomes substantially vested. (13)

If the plan fails to meet any one of these three provisions, the entire plan is tainted and taxation of the options would occur upon grant and potentially subject the employee to a 20% penalty on the deferred compensation. (14)

ISO plans are excluded from the IRC Section 409A rules. (15)

CHAPTER ENDNOTES

(1.) IRC Section 422(b)(1).

(2.) IRC Section 422(b)(2) and (3).

(3.) IRC Section 422(b)(4).

(4.) IRC Section 422(b)(5).

(5.) IRC Section 422(b)(6).

(6.) IRC Section 422(d).

(7.) IRC Section 422(a)(1).

(8.) IRC Section 422(a)(1).

(9.) IRC Section 421(b).

(10.) IRC Section 421(b), 3306(b)(19), and 3121(a)(22).

(11.) IRC Section 56(b)(3).

(12.) IRC Section 56(b)(3).

(13.) Treas. Reg. [section]1.409A-1(b)(5)(i)(A).

(14.) IRC Section 409A(a)(B).

(15.) Treas. Reg. [section]1.409A-1(b)(5)(ii).
Figure 27.1

Comparison OF NQSOs AND ISOs

                         Nonqualified Stock        Incentive Stock
                               Options                 Options

Taxation at Grant       No tax consequences     No tax consequences.
                        unless the option is
                        publicly traded.

Number of Options       Unlimited               Only options on stock
                                                with an underlying
                                                value of $100,000,
                                                determined as of the
                                                grant date, may first
                                                be exercisable by an
                                                employee in any given
                                                calendar year.

Exercise Price          Can be set at any       Cannot be lower than
                        amount.                 the fair market value
                                                of the stock on the
                                                grant date. If the
                                                employee is a 10% or
                                                greater shareholder,
                                                the exercise price
                                                must be at least 110%
                                                of the stock's fair
                                                market value on the
                                                grant date.

Taxation at Exercise    Difference between      No tax consequences
                        fair market value and   for regular tax
                        exercise cost is        purposes. The
                        taxable as ordinary     difference between
                        income and is subject   the fair market value
                        to payroll taxes. If    and exercise cost is
                        the stock is            a positive AMT
                        restricted, taxation    adjustment in the
                        is deferred until       year of exercise
                        restrictions lapse      unless the stock is
                        unless an 83(b)         sold in a
                        election is made by     disqualifying
                        the employee.           disposition in the
                                                same year.

Payroll Taxes           Must be collected       Federal payroll taxes
                        upon exercise.          are not required upon
                                                the exercise or
                                                disqualifying
                                                disposition. Review
                                                state and local
                                                requirements.

Taxation at             Gain or loss on sale    If the sale is a
Disposition             is recognized. Basis    qualifying
                        of stock is equal to    disposition, any gain
                        the exercise cost and   is taxed as a long-
                        the amount of           term capital gain.
                        ordinary income         The difference
                        reported on the         between he basis of
                        exercise.               the stock for regular
                                                tax and AMT purposes
                                                is a negative
                                                adjustment for
                                                determining AMT in
                                                the year of
                                                disposition.

                                                If the sale is a
                                                disqualifying
                                                disposition, the gain
                                                on the sale is
                                                ordinary income to
                                                the extent of the
                                                spread at the time of
                                                exercise. Any excess
                                                gain is capital gain.
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Publication:Tools & Techniques of Income Tax Planning, 3rd ed.
Date:Jan 1, 2009
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