R E L A T E D R E S O U R C E S Check our Reduce Your Taxes step-by-step. Look up our quick reference on taxes. R E L A T E D A R T I C L E S Eight ways to avoid the AMT sting R E L A T E D S I T E Want Congress to fix the AMT? Check out reformAMT.org. |
To avoid a tax burn, know your (stock) options Those stock options that made paper millionaires of dot-commers have turned on many of them with a nasty -- and very real -- bite. Here's how to collect your own options gains without the pain. By Jeff Schnepper In 1999 and into 2000, everybody (except us) was getting rich on stock options. Then the options that were supposed to turn into riches instead became tax nightmares.
If the options problem weren't so painful, it might be funny. But, for many people, it is very painful. Problems can erupt when you exercise your options. The exercise can trigger a tax hit whose severity depends on the terms of the option grant. For one Cisco Systems engineer, the severity was enormous. He exercised incentive stock options to buy 100,000 Cisco shares in March 2000 at 5 to 10 cents a share. He exercised the options when Cisco was selling at around $62 to $63. On paper, he was ahead $7 million, and, under the rules of the Alternative Minimum Tax, he was liable for taxes on the gain on the day he exercised the options. So, by April 2001, he faced a $2.5 million tax bill on the shares under the AMT rules, which are designed to ensure everyone pays some tax. Worse, the value of the engineer’s shares had fallen some 80%. Our goal is to help you survive the options quagmire. To do that, you must understand the different kinds of options and how options work. Then, if you do get some of your compensation in options, you can start planning now to limit the tax problem. There are two kinds of stock options. Those that have special tax benefits are called Incentive Stock Options (ISOs); those that don’t, Non-Qualified Options (NQOs). Here’s a summary of how they’re structured and the benefits you get: Incentive Stock Option features Typically granted to: Executives; senior management. Option price: Must be granted at a price that at least equals the stock’s market value at the time of the grant. Taxation
Vesting: May be subject to a graduated vesting schedule or cliff vesting schedule, according to the terms of the option agreement. A graduated schedule vests a percentage of the options each year for up to seven years. On a cliff vesting schedule, the options are all vested at once after a specified number of years. Expiration: Typically 10 years following the grant date. Terms may vary from company to company. Companies are required to disclose the terms of their incentive option plans to shareholders. Planning: Remember that incentive stock options can trigger alternative minimum tax treatment. (The AMT still applies despite a modification in the new tax bill designed to provide a little relief.) If the value of the stock subsequently falls, you may still be subject to the additional taxes the AMT can generate. One way to get around the problem is to sell your shares by Dec. 31 of the year you exercise your options. Then, your tax is only on the gain between exercise price and sale price, and it’s not subject to the AMT. Whatever you do, check with a tax advisor who knows the tax rules on options before making your move. The wrong move can be very costly. Non-Qualified Stock Option features Typically granted to: All employees in a company. Option price: May be lower than the value of the stock on the date of the grant, making it instantly "in the money.” Taxation:
Vesting: May be subject to graduated or cliff vesting, under the terms of the company’s option agreement. Expiration: Typically 10 years following the grant date. As with incentive option plans, each company has its own rules on options. Planning: Remember, your employer reports the gain you realize when you exercise your options on your W-2 and withholds income and employment taxes on that amount. Typically, you would pay your employer the amount of any withholding, along with the exercise cost of your options. One other stock plan There’s one more variation on this theme that I see. It’s called the junior stock plan. This is how it works: Your employer issues special “junior” non-voting common stock that pays regular dividends. These shares can be exchanged for regular common stock, share for share, at a specified date, if the holder meets certain conditions. The junior shares are sold to you at a bargain price -- for example, $20 when the regular common is trading at $30. You pay income taxes on the $10 price spread. At the end of the term, when the regular common stock is trading at, say, $80, you swap your junior shares for the regular common shares. On the sale of the regular common stock, you have a tax basis of $30 -- the $20 paid for the shares, plus the $10 on which you were taxed. You then have a gain of $50 per share -- $80 less your $30 basis -- which is taxed at the maximum 20% rate. Stock options can offer you some great choices and potential for accumulating wealth. They are intended to provide an incentive for an employee to continue working for a company. They are not intended to let you get rich quick. If you’re lucky enough to receive options, exercise them carefully. The choices you make -- if not made wisely -- can cost you plenty. So, think before you exercise and make the right choice for you. 
| ||||