Know Your Options.

• Author: Hess, Matthew V.
• Position: Brief Article

ISO Tax Traps Can Ambush the Unwary

Employee stock options have ballooned in popularity.

According to the National Center for Employee Ownership, in the last decade the number of employees receiving stock options has skyrocketed from one million to 10 million!

Why are stock options so popular? Employees love them because options allow the worker to benefit from the increasing value of their employer's stock, without initially spending any of their own cash. Corporations favor them because stock options granted to employees are not considered company costs for financial accounting purposes.

Employee stock options come in two flavors: incentive stock options (ISOs), which are discussed here, and nonqualified stock options (NQSOs), which are not. ISOs are issued with an exercise, price equal to the stock's fair market value on the date of grant, so employees benefit only if the underlying stock's value appreciates thereafter.

ISO TAX BENEFITS

An ISO's primary tax benefit is that the employee does not recognize taxable income when the corporation grants the option. Similarly, the employee generally does not recognize regular taxable income when the ISO is exercised (i.e., when the employee purchases the employer's stock at the exercise price designated in the ISO).

Accordingly, if the tax requirements are satisfied, all appreciation in the stock's value from the grant date to the day before the stock is sold will not be taxable -- for regular tax purposes. Only when the stock purchased with the ISO is sold will the employee be taxed -- for regular tax purposes.

ISO TAX TRAPS

1. The Option Trading Trap. An ISO should not be transferred except upon the employee's death. Any lifetime transfer of an ISO makes the employee immediately taxable on the amount received from the transfer. That income is taxable as ordinary income, with federal rates of up to 39.6 percent -- far higher than the 20 percent capital gains tax rate usually afforded an ISO.

2. The Price of Upward Mobility. If an ISO is exercised more than three months after the employee leaves the company granting the option, the employee does not get the capital gains tax rate when the option is exercised. The taxable income equals the stock's fair market value at exercise minus the amount paid to exercise the option.

   Tad is granted an ISO to buy MarketCorp stock at $25, then takes a new job. Four months later he exercises the ISO when MarketCorp is trading at $65. Even though Tad did not yet...