ISO exercise involving stock swap requires complex recordkeeping.

• Author: Lerman, Jerry L.
• Position: Incentive stock options

Stock options have become an increasingly important and common component of the compensation package for many taxpayers. Previously limited to high-level executives, participation in stock option plans is now often made available to rank-and-file employees. When the options being granted are "qualified" or incentive stock options (ISOs) under Sec. 422, a taxpayer must deal with potential alternative minimum tax (AMT) consequences if he exercises and holds the options. Employers generally communicate this fact to employees in the most basic fashion. The employee recognizes no income for regular tax purposes on exercising an ISO. However, the spread between the stock's fair market value (FMV) on the exercise date and the exercise price, known as the bargain element, is a preference adjustment that could give rise to AMT. The spread also creates a tax basis in the shares acquired that is greater for AMT than for regular tax. At this point, most employees (and certainly most professionals) understand the effect of a straightforward exercise when an employee simply pays cash.

An employer may offer ways to exercise options other than simply paying cash. One of those alternatives is to exchange shares of employer stock that an employee may already hold (stock swap). In a stock swap, the employee pays the exercise price for the new shares by surrendering shares held (old shares). The credit given for the old shares is based on the stock's current value. The employee gains additional shares because of the bargain element associated with the ISO; see Exhibit 1 (Part A).

Exhibit 1: ISO Exercise Using Stock Swap Facts: A taxpayer holds 200 shares of employer stock from the exercise of a prior ISO. The option price was $27.50 per share and the FMV at that time was $50 per share. A subsequent option is exercised on 500 shares with an option price of $50 per share ($25,000 in total). At the time of the second exercise, the stock's FMV is $125 per share. The taxpayer exchanges 200 shares at $125 per share to pay the exercise price. Part A Mature shares ISO Capital gain holding holding Date Transaction period period 1/1/99 Exercise 1/1/99 1/1/99 1/1/01 Exchange Shares surrendered (old shares) 1/1/01 Exercise Exchange shares 1/1/01 1/1/99 Added shares 1/1/01 1/1/01 Part B Immature shares 1/1/99 Exercise 1/1/99 1/1/99 7/1/99 Exchange Shares surrendered (old shares) 7/1/99 Exercise Exchange shares 7/1/99 1/1/99 Compensation recognized (200 shares x ($50 - $27.50)) Added shares 7/1/99 7/1/99 Part A Mature shares (1) Certificate Date Transaction...