With the stock market having nearly doubled over the last two years, many individuals holding stock options that they received from their employers are giving serious consideration to cashing out the value in these options. This article discusses the two main types of options and explains the different AMT issues associated with each.
For tax purposes there are two types of stock options – ‘qualified’ and ‘nonqualified. ‘ The official term for a qualified option is Incentive Stock Option, usually referred to as an ‘ISO. ‘ Each employer has the discretion, through the development of its plan, as to which type of option it grants to the employee, and it isn’t uncommon for some employees to have both types. It is important to point out here that it is the duty of the individual to figure out what he has.
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A stock option, like every other option, is a contract giving one person’s right to buy property from another person at a preset price. If the underlying property (stock) increases in value, the value of the option correspondingly increases. If the value of the stock decreases, the option has no value. Options generally have a fixed term – five to ten years for stock options is common, so the employee must act within this period or the option will lapse.
FAQ’s: Value Options?can someone please tell me what Value Options is?
options that have value
Example – an employee is granted an option to buy 1, 000 shares of his employer’s stock at today’s value of $50. If the stock increases to $60 before the option lapses, the employee can exercise the option, effectively buying the shares from the employer at a discount and, in this example, realizing a $10, 000 gain. To alleviate the hardship of asking the employee to write a cheque for the $50, 000 exercise price, employers commonly arrange with a factor to allow what is called a ‘cashless’ exercise involving a same day sale. In this situation, on the date of exercise the broker sells an equal number of shares, and then sends the employer the $50, 000 along with enough to meet the tax withholding requirements. Then, at the end of the market’s three-day settlement period, the net amount ($10, 000 less taxes) is credited to the employee’s account.
The first choice for the employee is to buy the stock at $5 a share and then sell the shares on as soon as the specified time period in the market is up at $10 a share. This leave the employee with a profit of $3 per share or $150 total profit on the 50 shares.
Another option is to sell a portion of the shares after the specified time period and keep some to sell at a later date for potentially higher profits.
Nonqualified option – on the date of exercise the $10, 000 during the above example is taxable income. This is ordinary income, not capital gain, just as though it were part of the employee’s salaries and wages. The $10, 000 will be part of taxable income reported under the employee’s W-2 at the end of fiscal year.
ISO (qualified option) – The $10, 000 won’t be taxed as income on the date of exercise. Instead, it is a tax preference item for purposes of the AMT, meaning that Alternative Minimum Taxable Income will be more than the employee’s Regular Tax taxable income by $10, 000. The number in this example is relatively small. However, if the preference item from an ISO exercise is large enough the employee easily can find himself stuck in the AMT. If the individual already is in the AMT, the hit from an ISO exercise will make it just that much more painful.
The exercise of a nonqualified option doesn’t have any direct AMT consequences. As an individual’s taxable income increases, however, the Alternative Minimum Tax exemption is phased out, so testing for the effect of this is important before exercising even a nonqualified option.
Especially critical, however, is tax planning before doing an ISO exercise. In order to exercise an ISO without triggering the Alternative Minimum Tax, the individual has something to do the tax calculation under alternative assumptions as to the extent of the exercise, as well as consider doing the exercise partially in one year and partly in the next. By doing this it surely is possible to reduce the impact of an ISO exercise. Note also that the employee has a period of time after the exercise within which a selling of the stock will constitute a ‘disqualifying disposition,’ thus negating the AMT effect and retroactively treating the transaction as though it were instead a nonqualifying option.
The underlying investment decision with respect to the right time to cash out of employee stock options must, of course, must form the individual’s primary focus, but if that exercise will bring along with it a big AMT hit taxes need to be taken into account in deciding how many options to exercise and in what year they’re exercised. That nice chunk of extra income the employee thinks he is getting can be seriously eroded by improper tax planning.