Allow us to congratulate you for working for a company that values you as an integral employee! Your stock options can be a great wealth-builder when combined with prudent tax planning. Working with a qualified, proactive CPA to create a tax plan could save you hundreds or thousands of dollars in taxes (or hundreds of thousands of dollars even!). Most of the time, tax planning should be done prior to making changes to your portfolio to empower you to find the best course of action to meet your goals.
But, even if you’ve gone ahead, a tax projection can be done to let you know if you’re covered for tax time.
First, you need to decide on your initial goals….
1) Would you rather maximize the cash you receive from the sale of that stock?
OR
2) Would you like to minimize your taxes?
OR
3) Would you rather reduce your cash outlay when you exercise the options? (To exercise the options means that you’ve “exercised”, or used, your option to buy the underlying stock—at which point, you no longer own a stock option—you own the stock instead.)
OR
4) Perhaps you would like to accumulate a large equity stake in your employer over the longer term because you believe the company stock will be worth considerably more in the future?
Secondly, there are two main types of stock options, and it is important to know which of these you have been offered. Check your employer’s documentation to see what you were given. Here are the two main types and their differences:
Nonqualified Stock Options (NQSO’s)
The tax treatment of NQSO’s depends primarily on whether there is an ascertainable fair market value for the stock, such as for publicly traded stocks, and whether the stock has vested (when a stock vests, it means that you cannot lose the stock if you decide to leave the company—it is yours until you sell it).
If there is no ascertainable fair market value: Most of the time, a grant of NQSO’s is not going to be a taxable event on the date of grant (in other words, it would not affect your tax bill in the year you received the grant of stock options). They would instead be taxed in the year that they are exercised. Most of the time, the NQSO’s are not exercisable until the underlying stock is vested.
However, if there is an established fair market value: If the NQSO has an ascertainable fair market value, they are taxed in the year of grant! And, then, you will have been deemed to have received ordinary income equal to the fair market value as of the date of grant, less the exercise price paid. An example would be if your NQSO at date of grant was worth $50 on the market, and if your company gave you the option to exercise at $30 per share, you would have received $20 per share in ordinary income to be taxed at the higher ordinary income tax rates.
If you had been granted 1,000 NQSO’s, that would mean you had an extra taxable $20,000 in ordinary income for the year. If you had been granted 5,000 NQSO’s, you would have to cover $100,000 in ordinary income for the year—do you feel confident that your taxes withheld from your regular paycheck are enough?
It’s still a nice benefit from your employer, of course, but knowing that these events may add to your tax bill for the year will likely shift some of your decision making. You may want to proactively set aside some cash in savings to send in a quarterly estimated payment. Or, you may choose to sell a portion of the stock in the same year to cover your extra tax liability (don’t forget to consider the short-term capital gains or losses from doing so!).
How much of the stock would you have to sell to cover the tax? Or, what dollar amount should you send in with your quarterly estimated payment? Would you rather just liquidate all the stock to minimize your exposure?
Qualified Stock Options, also known as Incentive Stock Options (ISO’s)
The tax treatment of ISO’s depends on whether the disposition (or sale) of the stock from the ISO is a qualifying disposition. A qualifying disposition gives you, as the owner, the ability to exercise the options without having to pay regular tax (it is still included in the AMT* income for the year of exercise, if you are subject to Alternative Minimum Tax—no, AMT doesn’t stand for A Major Tummy-ache!)
After you have exercised the ISO’s, and once you dispose of the underlying stock in a qualifying disposition, if the price you paid to exercise the ISO is less than the price you received for selling the stock, there will be some long-term gain for regular tax purposes (as opposed to ordinary income, which is taxed at much higher rates). Long-term gain is taxed at capital gains tax rates, which is preferable.
So, how do you sell the stock in a qualifying disposition? Great question. Here are the specifics:
The disposition (or sale) of the stock must be more than two years after the date of grant,
AND the disposition of the stock must be more than one year after you exercised the options. So, in other words, you would have owned the underlying stock long enough that it would be considered a long-term investment.
Also, you must have been an employee of the corporation that granted you the options at all times from the grant date to three months before the exercise date.
The stock may also be sold in a disqualifying disposition, which happens when the stock from the ISO’s is sold without meeting the three holding requirements listed above. The income from the exercise of the options (which is the difference between the Fair Market Value at the time the stock vested, and the exercise price) is taxed at ordinary tax rates for both regular tax and AMT*, not the lower capital gains tax rates.
The third thing to consider are the types of things you can do with your stock options and the underlying stock, such as:
Exercise and hold,
Exercise and sell (or sell in a qualifying disposition),
Sell in an intentional disqualifying disposition,
Or exercise and sell to cover the taxes.
Many tax professionals aren’t known for giving proactive advice, so that makes us unique here at T. S. Allen & Associates. Whether you’re planning for a merger or acquisition, or whether you’re just trying to determine the best strategy for your option exercise and sale events, let us do some tax planning on your behalf so you can know your options (ha-ha, pun intended)!
* For the purposes of this article, we’ve left out many of the specifics behind which taxpayers are subject to Alternative Minimum Tax. The topic is too complex for the nature and purpose of this post and would need to be explored on an individual basis with our clients that hire us for tax planning. In our experience, an individual tax projection tends to be the best illustration of the effects of AMT.
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