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Types of Options
§§421-4 of the Internal Revenue Code describe two types of employment related stock options : Employer Stock Purchase Plans (ESPPs) and Incentive Stock Options (ISOs.) An important IRS rule is that stock acquired through an ESPP or ISO generally does not qualify for favorable tax treatment if it is sold or gifted or otherwise transferred within two years of the date of grant nor within one year of the date of exercise. The primary exceptions are death, transfers incident to divorce and using ISO or ESPP stock to exercise ISOs. A premature transfer is a "disqualifying disposition."
Qualified options can only be excised by the employee or by the employee's executor and therefore statutory options cannot be gifted or donated to charity. Some attorneys believe that statutory options cannot be transferred to a living trust.
On death, ESPPs and ISOs are stepped up in value and the stock can be transferred before the holding period restrictions run without triggering a disqualifying disposition. An option with a $10 exercise price is valued at $5 for federal estate tax purposes if the fair market value of the stock is $15 on the date of death. The stock purchased by exercising this option will have a $15 basis. Since the stock was not acquired from the decedent but is the result of exercising an option acquired from the decedent, the holding period probably begins on the date of exercise rather than being automatically long term. For additional information see Reg. 1.423-2(k)(3) and Carol Cantrell "Living and Dying with the Complex Rules of Incentive Stock Options" Journal of Taxation 87(2), August 1997.
There are also "nonstatuatory" or "non qualified" options (NQs or NonQuals.) The two year/one year holding periods do not apply to NonQuals and vested options can be gifted and can be donated to charity.
Income Tax Treatment
An ESPP allows employees to purchase employer stock at a discount, usually 15%. The plan must be non discriminatory and no employee can be granted options to purchase more than $25,000 worth of of stock in a single year.
Exercise must occur within five years of the date of grant and within three months of leaving employment. As a practical matter, many plans operate with payroll deduction and the grant and exercise dates are essentially simultaneous. Commonly, employees will not hold the stock but will realize the value of the discount by selling the shares soon after exercise.
There is no taxable event on the date of exercise but the discount is subject to withholding for FICA and other employment taxes. See IRS Publication 15-A. An analogy is deferred compensation where the income tax is deferred and the employment tax is due immediately.
When the stock is sold, the discount is taxed as ordinary income but any appreciation is taxed at long term rates. If the market value when sold is less than the fair market value when exercised, there is no capital gain and a smaller ordinary income component. If the sale price is less than the exercise price, there is a long term loss. If the holding periods are not satisfied, all gain is taxed as ordinary income.
The exercise of incentive stock options is not a taxable event for ordinary income tax purposes but the difference between the fair market value on the exercise date and the exercise price is an AMT preference item. Oftentimes, this means that there is a substantial tax liability upon exercise. It is possible that some or all of this extra tax will be refunded when the stock is sold.
The employee has the responsibility to determine fair market value. Sometimes, the company will announce a valuation and, if the company is issuing new options, the newly announced exercise price might serve as an estimate of market value. When the fair market value is unclear, as with pre-IPO stock, it may be necessary for the employee to pay for a professional valuation.
There is currently no tax withheld when an ISO is exercised. However, on January 18, 2001, the IRS issued Notice 2001-14 and announced that they are studying income tax withholding and FICA and FUTA tax. They promise that there will be no changes before January 1, 2003. Until then at least, the employee is on his or her own to make the estimated tax payments necessary to avoid underpayment penalties. It is usually wise to obtain professional assistance with these calculations.
The difference between the sale price and the exercise price is taxed at long term rates if the holding periods are satisfied.
If the stock is sold or gifted prematurely, the difference between the sale price and exercise cost is taxed as ordinary income.
If the stock is transferred prematurely in the year of exercise, AMT is not a factor and the net effect is similar to a "same day sale" which is the exercising and selling in the same transaction. A disqualifying disposition can be a good idea if the stock value plummets in the year of exercise.
But, if the stock is transferred in a disqualifying disposition the year after exercise, the employee could be in the unfortunate position of having a big AMT tax bill in the year of exercise which they might not get fully refunded in the year of disposition. Many people need to sell the stock to pay the tax bill. A common strategy is to exercise before April so that a sale in the April of the following year is not a disqualifying disposition.
Income from the disqualifying disposition of a qualified option is NOT subject to FICA or FUTA taxes. See IRS Notice 87-49.
There is a $100,000 limit on the value of ISOs that an individual employee is entitled to exercise in any given calendar year. This value is based on the fair market value of the stock on the grant date. If an employee is granted options which exceed this limit, the excess options are treated as non qualified options. For more information and examples, see RIA's "Incentive Stock Options and Nonstatuatory Options," October 1999.
Incentive Stock Options (ISO) must be exercised within ten years of grant and within three months of leaving the employer.
ISOs issued from 1997 through 2001 are non qualified for California purposes if the employee earns more than $40,000 or is granted more than 1,000 shares.
The exercise of a non qualified option is a taxable event. The employee recognizes ordinary income on the difference between the fair market value on the exercise date and the exercise price. The employer is supposed to withhold federal and state tax, the withholding rates are usually at 28 and 6% respectively, as well as FICA and other employment taxes. The ordinary income is usually run through the payroll system and reported on the employee's W-2.
The difference between the sale price and the fair market value on the exercise date is taxed as a long term capital gain if the sale is more than one year after exercise. If the non qualified stock is sold prematurely, the difference between the sale and fair market values is taxed as compensation. That is, ordinary tax rates and employment taxes.
Commonly, employees will realize the value of the discount by selling the stock on the day of exercise in a "same day sale." The motivation is partly to raise cash to pay for the exercise and tax withholding.
For information on this important tax savings device, click here.
Tax Preparation Pointers
The employee's portfolio could be the result of exercising ESPP shares, ISOs and NonQuals on different dates at different prices. Good records are vital and it is worth the time to keep records in order.
Always reconcile the employee's option schedule and brokerage statements to the amounts shown on the W-2. Every once in a while, there is a difference. Perhaps the employee sold the stock after moving to a new employer. When there is a difference, it is usually a large difference.
Since employers do not always identifying disqualifying dispositions, it falls to the preparer to review the holding periods for each sale. Ordinary income from a disqualifying disposition or the premature sale of NonQuals goes on line 21 of the federal return if it not included in the W-2.
There will usually be a small Schedule D gain or a small loss on a same day sale because the sale price seldom matches the market price assumed in the employer's calculations.
It is imperative to plan the exercise/sale of options, especially when you have both ISOs and NonQuals. It is usually possible to delay the payment of tax and it is sometimes possible to save tax but, because the rules are complex and interactive, the best scenario is seldom obvious in advance. Planning an option exercise and/or transfer requires the explicit calculation of tax effects since the use of rules of thumb can provide misleading or erroneous results. Advice from a knowlegable professional should be considered.
Markets do not always go up. It may be possible to salvage ISO stock which depreciated after exercise by a disqualifying disposition in the same tax year. To learn more about this complex decision, click here.
Delaying and reducing tax is not the only planning consideration. Often, the value of the employer's stock dominates the employee's net worth and it is prudent to sell some of this stock to diversify the portfolio. Older employees who are charitably inclined can diversify, obtain income and benefit a charity by donating low basis stock to a CRAT or CRUT. (The law was changed a few years ago and the tax benefits are no longer attractive for younger employees.)
Gifting appreciated stock after any holding periods expire can be an attractive. The donor's heirs receive more money after gift tax than they would after estate tax because the estate tax is an inclusive tax while the gift tax is an exclusive tax. (That is, estate tax is assessed on the value of a bequest plus the associated tax but the gift tax is assessed on the value of the gift alone.) But remember that gifted stock does not receive a step-up in basis and that the loss of stepped-up basis partially offsets the estate tax savings.
Warning: Since there are discussions in the US Congress to repeal the gift and estate tax system, think twice before making taxable gifts large enough to trigger the actual payment of gift tax!.
Another estate planning technique is to gift vested options. (NonQuals only please; one cannot gift ISOs or ESPP options.) When the options are exercised, the donor rather than the recipient recognizes income and employment taxes. Although the beneficiaries are benefited by the payment of this tax, the gift tax is an obligation of the donor. Therefore, paying the gift tax is not considered to be a taxable gift, much as paying income tax on a defective grantor trust is not considered a taxable gift.
For estate tax purposes, NonQuals are valued at the difference between the fair market value of the underlying stock on the date of death and the exercise price. If the options were exercised before death, the estate tax liability would be lower because of the income tax liability upon exercise reduces the taxable estate. Thus more estate tax is paid on unexercised options. A similar situation occurs with IRAs and pension accounts. Section 691(c) includes a provision to rebate the extra estate tax when the option is exercised but this adjustment is imperfect and the repayment might be delayed for several years. This is not a consideration if the recipient is a charity. Thus, when there is charitable intent, it is worth running the numbers to quantify the benefit from giving NonQuals to charity and other assets to non charitable beneficiaries.
There are a variety of planning techniques involving CRUTs and CLATs and life insurance.
Valuation is a big issue with gifted options. See Rev. Proc 98-34 for suggestions on valuation methodologies. Be sure to file a gift tax return to start the statue and preclude the IRS from revaluing your gift at a later date.
See David Hardesty's "Tax Planning with ISOs." David has a useful site (and an e-mail update service) dealing mostly with e-commerce. Also, Estate planning for stock optionsWhat to give, when, and to whom, by Sanford J. Schlesinger and Dana L. Mark, 92 JTAX 301, May 2000.
Kathleen Pender (San Francisco Chronicle, June 23,2000) suggests www.mystockoptions.com and www.optionwealth.com. I've not tried these sites but I am doubtful as to their utility since Pender says that you have to input fixed tax rates. I can't tell you how many times I have gotten the wrong answer trying to model AMT with a pencil and paper - you need a bona fide tax program for realistic results.
January 25, 2001