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| The Basics | To avoid a tax burn, know your (stock) options
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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 engineers 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 dont, Non-Qualified Options (NQOs). Heres a summary of how theyre 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 stocks market value at the time of the grant.
Taxation:- When granted: None
- At exercise: None, but the spread between the exercise price and the fair-market value may be subject to the alternative minimum tax. The logic is tricky, but here it is. Your vulnerability comes into play when the exercise price of your options is substantially lower than the fair market value of the shares on the day you exercise. If you fall into the world of the AMT, the difference between exercise and market price becomes taxable. If the spread is really large, the AMT can become very expensive very quickly. So, pay very close attention when you get your grant and when you exercise the options.
- After sale of stock: If you hold your shares for more than one year after exercise, the entire spread between the sale price and your cost is a long-term capital gain subject to the maximum 15% rate. If you dont hold for more than one year, you disqualify your ISO shares for long-term capital gains treatment. The difference between the fair market value at the time of exercise and the sale price is taxed as ordinary income..
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 law 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 its not subject to the AMT. But the gain will be short term, taxed at your higher rate. 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: - When granted: None
- At exercise: Ordinary income tax is due on the spread between the exercise price and the fair market value of the stock on the date of exercise.
- After sale of stock: In the year of the sale, capital gains taxes are due on the difference between your cost basis (the fair market value of the stock on the date you exercise your non-qualified option) and the price at which you sell the stock. If you sell within one year, the gain between the exercise price and the sale price is a short-term capital gain.
Vesting: May be subject to graduated or cliff vesting, under the terms of the companys 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
Theres one more variation on this theme that I see. Its 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 15% 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 youre 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.
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