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Stock option alternatives: considerations and implications for employees.

Employee compensation often comes in forms other than cash; for example, companies wishing to reward employees for good performance might grant stock options or restricted units. Stock options permit an employee to purchase the company's stock at a predetermined price. But employees who receive either incentive stock options (ISO) or nonqualified stock options (NSO) often exercise those options without fully comprehending the tax impact of the exercise. They also often allow stock options to expire, unaware that they have forgone an economic benefit. The ensuing discussion explains how stock options work and how employees can derive the maximum benefit from their exercise. It also examines restricted units and compares ISOs to NSOs, with respect to taxation and, more importantly, the economic impact on the taxpayer.


According to Technology Associates, 15% to 20% of public companies offer stock options to employees as part of their compensation package; more than 10 million employees are awarded stock options (Congressional Research Service, Employee Stock Options: Tax Treatment and Tax Issues, James M. Bickley, June 2012). Companies awarding compensation in the form of stock options may grant either ISOs or NSOs. Unlike with normal salaried compensation, stock compensation does not involve a cash expenditure by the company; in fact, options exercises represent a source of cash for the company granting the options.

Employees are typically granted a certain number of options (usually "call" options) to purchase shares of the company's stock at a predetermined option price (i.e., exercise price or "strike" price). Assuming that the value of the company's stock rises, the options would be "in the money," and an employee can exercise the option to buy shares of the company's stock by remitting the option price to the company. In return, the company issues shares to the employee, who could then sell the shares for a profit, if the market price exceeds the option price.

Employees granted either ISOs or NSOs should understand the tax impact of their exercise. Without proper tax advice and forewarning, taxpayers might find themselves owing taxes that they were not prepared to pay. On the other hand, employees frequently allow the stock options they have been awarded to expire. It is important for employees to understand that options that are in the money should not be allowed to expire and that there are alternatives for 'raping the benefits of stock compensation.

Types of Stock Options

ISOs differ somewhat from NSOs. Stock options are considered ISOs if they meet certain Internal Revenue Code (IRC) criteria; if the criteria are not met, the options are considered NSOs. (These criteria are beyond the scope of this article). The type of stock option that a company grants to employees is rarely within the employee's control; however, it is important for taxpayers to understand the choices available to them, as well as the tax consequences.

ISOs, along with options granted under employee stock purchase plans (ESPP) are statutory stock options. (This article does not address the taxation of ESPPs.) When ISOs are exercised--that is, an employee's rights in the stock are transferable or no longer subject to a substantial risk of forfeiture--the employee must include an adjustment in determining the alternative minimum tax (AMT). The amount of the adjustment is the amount by which the fair market value (FMV) of the stock exceeds the option price. The adjustment is utilized in determining AMT income. The resulting AMT must then be paid, in addition to the regular tax. The AMT basis of the stock is increased by the amount of the adjustment; no AMT adjustment is required if the stock is disposed of in the year of exercise (Taxable and Nontaxable Income, IRS Publication 525, Dec. 27, 2012, pp. 11-12).

Stock options that do not meet the criteria for statutory options are considered nonstatutory stock options. A taxpayer may have taxable income when these options are received. The amount of income and the time to recognize the income depends upon whether the taxpayer can readily determine the option's FMV. If an option is actively traded on an established market, the FMV is readily determinable. Certain other conditions apply when an option is not readily traded on an established market (IRS Publication 525, p. 11).

Employees receiving restricted units do not include those units' FMV in income until the stock has substantially vested. Until the stock becomes substantially vested, it is owned by the party making the transfer (i.e., the employer). When the property becomes substantially vested, an employee must include in income the restricted unit's FMV, less any amount paid by the employee. The holding period for the property begins when it becomes substantially vested (IRS Publication 525, p. 13).

Alternative Options

The most pervasive problem for taxpayers is the need to pay any tax triggered by exercising an option, as well as the need to come up with the funds to pay the strike price. The tax impact for an individual from exercising ISOs versus NSOs can be very similar. But understanding how the various options are taxed to the individual taxpayer is paramount to the decision-making process; thus, the tax impact of the numerous alternatives is explained below, using scenarios from practical applications.

Exercise and hold or exercise and sell immediately? Employees granted ISOs may exercise the ISOs and either hold the company stock or immediately sell the shares. The motivation for the decision to exercise and sell might be lack of funds to pay the exercise price, whereas the motivation to exercise the options and hold the stock might be the hope of future increases in the stock's FMV. Any future gains would then be taxed at the preferred long-term capital gains rate if the stock were held for more than one year, with the regular tax basis being the option price paid by the employee. It is important to note, however, that the AMT basis becomes the FMV on the date of exercise.

Exhibit 1 illustrates a scenario in which an employee with 1,200 ISOs elects to exercise those options and hold the company stock. The options have an exercise price of $26.53 and an FMV of $49.03 at the date of exercise. The AMT adjustment in this case would be $27,000 ([$49.03 - $26.53] x 1,200), resulting in an AMT of $5,408. The AMT raises the total federal income tax to $16,069. The tax basis of the stock is $26.53, which is the option price. Any future gains above the option price would be taxed at the preferred capital gains rate if the stock were held for more than one year. The AMT basis for the stock is $49.03--FMV on the date of exercise--and this is increased by the amount of the adjustment.


Comparison of Incentive Stock Option (ISO) Exercise to
Exercise Sell Immediately

                     ISO Exercise  Exercise         Supporting
                                   and Sell       Calculations

Number of options           1,200     1,200                 --

Exercise price            $26.53     $26.53                 --

Fair market value         $49.03     $49.03                 --

Alternative minimum      $27,000         --              1,200
tax (AMT) adjustment                         ($49.03 - $26.53)

Taxable income          --          $27,000              1,200
adjustment                                   ($49.03 - $26.53)

Total federal          $16,069 *    $17,498                 --

Funds required           $31,836                1.200 x $26.53
for exercise

Net funds generated           --     $20,163          Proceeds
from exercise                                        - $27,000
and sale                                            additional
                                                  tax - $6.837
                                                    [dagger] -
                                               [double dagger]

* Includes AMT of $5,408

[dagger] Tax with additional amount in income

[double dagger] Tax without additional amount in income

If the employee were to exercise and sell the shares immediately, $27,000 would be added to ordinary income, resulting in a slightly higher tax (shown in Exhibit 1). The taxpayer is not subject to an AMT on an exercise of ISOs it' the shares acquired through the exercise are sold in the same year.

What are the considerations for this employee? The decision to exercise the ISOs requires a cash payment to the company for the exercise price in the amount of $31,836 (1,200 shares x $26.53 exercise price). The AMT paid with the tax return is a tax that might never be recovered. Alternatively, the employee may exercise and immediately sell the shares. Taking into account the slightly higher federal taxes (and ignoring state income taxes), the employee will net $20,163. This amount represents the net proceeds from the sale ($27,000), less the additional federal taxes of $6,837 ($17,498 - $10,661) on this ordinary income. Allowing the options to expire should not be considered (unless they are "underwater"--that is, the exercise price is below the market price) because, by electing to exercise and sell immediately, the employee will have received some cash.

The downside to electing an ISO exercise versus deciding to exercise and sell immediately is that there is never a guarantee that the value of the stock will increase in the future. The AMT paid in the year of exercise can never be recovered if the value of the stock falls below the market price on the date of the exercise. The courts have, on numerous occasions, ruled that AMT losses from the subsequent sale of stock (acquired through the exercise of ISOs) below its option price are limited to $3,000 when computing the AMT. The courts have also ruled that the AMT capital losses cannot be carried back (see "AMT Capital Loss Cannot Be Carried Back," Practical Tax Strategies, Thomson Reuters RIA, vol. 76, no. 6, 2006, pp. 362-363).

ISO exercise or swap? One reason to elect to exercise an ISO might be the prospect of significant growth of the company's stock. Exhibit 2 uses the example of an employee who is granted 8,000 ISOs with an option price of $21.57 and an FMV at the date of exercise of $62.55. The AMT adjustment would be $327,840, resulting in a significant AMT liability. The tax basis of the stock is the option price, $21.57. Any future gains above the option price would be taxed at the preferred long-term capital gains rate if the stock were held for more than one year. The AMT basis for the stock is $62.55, the FMV on the date of exercise.

The employee also has the option to exercise and sell at least a portion of the 8,000 options in what is termed a "swap." This can be done if the employee does not have the funds needed to pay the option price and is willing to accept fewer than the number of shares associated with the grant. The company must sell enough shares to pay for the option price. The employee would come away with fewer than 8,000 shares of stock., because a portion of the shares were sold by the company in order to generate the proceeds needed to cover the option price on the stock options that are ultimately exercised.

If the employee chooses to swap, the employee would receive a net 5,242 shares because 2,758 shares were used to pay for the options. The taxpayer's basis in the 5,242 shares received is zero. This means that any subsequent gain on the sale of these shares would be taxed as the difference between zero and the selling price. The basis is zero because the employee was not required to contribute any money out-of-pocket for this exercise, as with a full exercise of 8,000 options. If 8,000 options had been exercised, the employee would have been required to pay the option price; this, in turn, would create basis for the shares received.

The outcome of the swap versus the full exercise is that the AMT liability would be about the same. For this reason, Exhibit 2 focuses on the AMT liability rather than the total federal tax, as in Exhibit 1. The reason that the AMT liability is similar for the swap versus the full exercise is that the AMT adjustment is approximately the same in either case. If the employee decides to swap, the AMT adjustment would be $327,887, representing the difference between the option price of $0 (the employee did not contribute any cash to this transaction) and the FMV of $62.55 on 5,242 shares (not 8,000 shares). The amount of the AMT adjustment has not materially changed from what the AMT adjustment was with an exercise of the 8,000 options ($327,840); what changed is the number of shares used to calculate the AMT adjustment (8,000 versus 5,242) and the spread (i.e., the bargain element) used to calculate the AMT adjustment (see the supporting calculations in Exhibit 2).


Comparison of Incentive Stock Option (ISO) Exercise to Swaps

               ISO Exercise      Swap           Supporting

Number of             8,000       --                    --

Number of               --        5,242   8,000 x $21.57 =
options                           (net)    $172,560/$62.55
                                                   = 2,758

Exercise price      S21.57       $21.57                 --

Fair market         $62.55       $62.55                 --
value (FMV)

Alternative       $327,840           --              8,000
minimum                                  ($62.55 - $21.57)
tax (AMT)

AMT adjustment          --     $327,887     5,242 x $62.55

AMT liability     $106,001     $106,015                 --

Funds required    $172,560           --     8,000 x $21.57
for exercise

Funds required          --            0                 --
for exercise

What are the considerations for this employee? The employee's decision should revolve around cash considerations and the number of shares desired. An exercise of 8,000 options for this taxpayer means that the employee will pay the company $172,560 (8,000 x $21.57 exercise price). In addition, AMT will be owed. A swap does not require a cash outlay on the part of the employee to cover the exercise price; however, the employee accepts fewer shares with a lower (zero) basis and must still pay about the same AMT as with the exercise of 8,000 options. Unless the options are underwater, they should not be allowed to expire, especially considering that the employee has the option to exercise and immediately sell the shares. (The benefit of a decision to exercise and sell immediately is illustrated in Exhibit 1.)

ISOs versus NSOs. Although employees are not in a position to choose between ISOs and NSOs, it is important to understand the similarities and differences. The taxation of stock acquired through the exercise of NSOs works differently from ISOs. The option price is often set equal to the market price on the grant date. The difference between the FMV of the stock on the date of exercise and the option price is added to ordinary income in the year the NSOs are exercised. Regular tax is paid on this difference, which creates basis in the stock equal to its FMV on the date the options are exercised. Because the basis of the stock is its FMV on the date of exercise, any additional tax will only be paid on future gains realized beyond that FMV. If the stock were held longer than one year, the gain on the subsequent sale of the stock would qualify for long-term capital gains treatment.

Exhibit 3 illustrates what happens when an employee has been granted 4,000 NSOs. The option price is $26, and the FMV on the date of the exercise is $66.20 per share. The difference between the option price and the FMV of the stock--$160,800--is added to ordinary income, resulting in a regular federal tax of $106,973 for this particular employee this year. An exercise of NSOs does not trigger an AMT.


Comparison of Nonqualified Stock Options (NSO) to
Incentive Stock Options (ISO)

                     NSOs      ISOs      Supporting

Number of           4,000     4,000              --

Exercise price        $26       $26              --

Fair market        $66.20    $66.20              --

Taxable income   $160,800        --           4,000
adjustment                           ($66.20 - $26)

Alternative            --  $160,800           4,000
MinimumTax                           ($66.20 - $26)

Total federal    $106,973  $106,047              --
tax                              *

Funds required   $104,000  $104,000     4,000 x $26
for exercise

* Includes AMT of $52,138

If these were ISOs, on the other hand, the taxpayer would face an AMT liability of $52,138, raising the total federal income tax owed to $106,047. An exercise of NSOs is functionally similar to an exercise-and-sell decision, as seen in Exhibit 1. A taxpayer's total tax with an exercise of NSOs is slightly more than it would be with the exercise of ISOs. But it is important to recall that the decision as to which type of option is awarded an employee belongs to the company; it is the company's responsibility to meet the criteria for options needed to qualify as ISOs.

Which is more advantageous for the employee? If the employee exercises NSOs, the company must be paid $104,000 (4,000 x $26) for the exercise price. The federal income tax will be based on ordinary income of $160,800, included in taxable wages. The advantage to this inclusion is that it creates basis. The shares now have a tax basis of $66.20; if they are held for more than one year, any gain on the subsequent sale of the shares will be long-term capital gain. If the employee exercises ISOs, the company is paid the same option price, but there is the AMT liability--a tax that may never be recovered. The disadvantage is that the regular tax basis of the stock is $26, and the AMT basis is $66.20.

Taxpayers must keep in mind that the recent changes to IRS Form 8801 (Credit for Prior Year Minimum Tax--Individuals, Estates, and Trusts) attempt to refund a portion of AMT credits. From 2007 through 2012, for AMT credits that are four years old or older, taxpayers may be able to recover up to either 20% of the credit carryforward or $5,000, whichever is higher. Although there are adjusted gross income (AGI) phaseout restrictions and other rules, eligible taxpayers could receive a refundable credit.

Restricted Units

The taxation of restricted shares is a simpler process. An award of restricted shares is included in W-2 wages and taxed as ordinary income. Taxable income is calculated as the FMV on the date the shares are transferred. The FMV included in income becomes the basis of the stock to the employee. The basis for determining gain or loss when the property is sold is the amount included in income, plus any amount paid for the property. Companies are increasingly awarding performance shares, as well as awarding restricted shares. Performance shares are taxed the same as restricted shares, with the value of the shares on the date transferred included in wages.

Making the Right

Choice Stock options have provided a mechanism for companies to reward their employees' performance. Reaping those rewards, however, can come with surprising consequences to employees. When stock options are exercised and held, the employee must expend cash to effect the exercise. Not only is it a strain for many to come up with the cash in order to pay the company for the exercise, but it is an additional strain on resources to cover the taxes resulting from the exercise. In order for subsequent gains to be taxed at the preferred long-term capital gains rate, shares must be held for at least one year and one day after exercise.

An exercise of ISOs often triggers an AMT liability, which is not typically recovered in future years. The same holds true for a swap involving ISOs. An exercise of NSOs triggers ordinary taxable income; when the NSOs are exercised, ordinary income equal to the difference between the fair value on the date of exercise and the option price is taxed in the year of exercise. In both circumstances, the employee pays the exercise price to the employer. The tax impact of an exercise and sale of ISOs is similar to an exercise and sale of NSOs: both are taxed as ordinary income. If the stock is held for the requisite period of time and is later sold at a price above the value on the date of exercise, the resulting gain would be a long-term capital gain equal to the difference between the selling price and the value of the stock on the date of exercise.

More recently, many companies have turned to awarding restricted units as part of their performance award structure. The taxation of restricted units is a simpler process than that of NSOs and ISOs. The transfer of restricted units to the employee does not require a cash outlay by the employee. The value of the property received is taxed to the employee, who merely needs to have the ability to pay the tax on the ordinary income triggered by the award. From an economic perspective, this is the least burdensome alternative for the employee. An employee in a 25% tax bracket, for example, being awarded a restricted share with a value of $60 would simply pay the tax of $15 per share ($60 x 25%) and still have the ability to hold the stock in anticipation of future growth. The advantage for the employee is that basis is created when the shares are taxed to the employee at FMV. The basis of the shares is $60, and future gains would be the excess of the selling price over the $60 value on which the tax was paid.

Today, performance shares are the most common type of award for top executives at the 250 largest U.S. companies in the Standard and Poor's (S&P) 500 Index, according to Frederic W. Cook & Co. Inc. ("The 2012 Top 250 Report: Long-Term Incentive Grant Practices for Executives," October 2012). The taxation of these shares mirrors that of restricted units. Restricted units and stock options are still widely used as a form of compensation. Considering that restricted units are typically time-vested awards and that stock option grants usually expire 10 years from the grant date, many employees have these vested awards today. Decisions about exercise can be immensely important to these individuals, who will need informed professional advice.

Further Considerations

Employees have a wide variety of alternatives when granted incentive compensation in the form of stock options. With the help of their advisors, they should evaluate the economic benefit of each alternative, their own ability to raise funds required to effect the exercise, and the tax implications of each. Exhibit 4 summarizes the advantages and disadvantages of each option available to employees. Armed with the proper information, individuals can make a more informed decision.


Advantages and Disadvantages of Various Award Alternatives

Incentive Stock   Nonqualified    Exercise and  Swap       Restricted
Options (ISO)     Stock Options   Sell                     Units


Future growth    Future growth    Cash today    Future     Future growth
                                                growth     and no
                                                           cash payout

Gain at capital  Gain at          No AMT        Gain at    Gain at
gains rate       capital                        capital    capital gains
                 gains rate                     gains      rate and
                 alternative                    rate       no AMT
                 minimum tax


Payment of       Payment of       No growth     No         --
option price     option price                   payment
                                                of option
                                                but fewer

 AMT             Regular tax     Regular tax     AMT       Regular

In addition, the impact of state income taxes should also be considered An ISO exercise does not impact state income tax in the way that it impacts federal taxes, because of the AMT. When these shares are sold later, the gains subject to state tax would be the excess of the selling price over the exercise price. On the other hand, an exercise and immediate sale of shares results in additional taxable income included in the employee's W-2 as ordinary income on both the federal and state levels. The same holds true for restricted units. Typically, state treatment follows federal rules, but individuals are encouraged to seek help from their advisors before deciding upon a course of action.

Teresa M. Cortese-Danile, EdD, CMA, CPA, is an associate professor, Adrian Fitzsimons, PhD, CISA, CPA, is a professor, and Craig Latshaw, PhD, CMA, CPA, is an associate professor, all in the Peter J. Tobin College of Business, St. John's University, Staten Island, N.Y.
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Title Annotation:corporate finance
Author:Cortese-Danile, Teresa M.; Fitzsimons, Adrian; Latshaw, Craig
Publication:The CPA Journal
Geographic Code:1USA
Date:Aug 1, 2013
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