Stock Option Tax Rules Business Lawyers Should Know
| Publication year | 2018 |
| Author | Robert W. Wood |
Robert W. Wood
Robert W. Wood is a tax lawyer with www.WoodLLP.com, and the author of numerous tax books, including Taxation of Damage Awards & Settlement Payments (www.TaxInstitute.com). This discussion is not intended as legal advice.
Employees who work for a salary and a cash bonus may not know much about stock options or restricted stock. But lawyers representing employees (or independent contractors) with these increasingly important forms of compensation should know the sometimes confusing tax rules that apply to stock-related compensation. In the corporate world, equity and equity-based compensation are major parts of the playing field. And with start-ups, this can be a key reason for candidates to join. In many jobs, the biggest paydays are from equity, not from cash.
Executives, rank and file workers, and even consultants might be offered stock or options in lieu of, or in addition to, their cash compensation. Even outside lawyers and other consultants can get a piece of the action, since non-employees (meaning independent contractors) sometimes receive options or restricted stock, too.
All of them may need advice. If a company offers your client restricted stock or stock options, then there can be tax and economic advantages to accepting this equity, but there can also be tax traps. And your client might not know that he or she walked into a trap until years later.
Let's start with stock options. There are two types of stock options that are issued as compensation for services, and the tax rules that apply to them are quite different. There are incentive stock options (also called ISOs) and non-qualified stock options (also called NSOs).1 Some employees receive both. Your client's plan (and each individual option grant) should expressly state which type of option is being granted.
ISOs are taxed the most favorably. There is generally no tax at the time they are granted.2 There is also no "regular" tax at the time they are exercised.3 Thereafter, when the holder sells shares acquired on exercise of the option, he or she will pay tax, hopefully as a long-term capital gain. 4
But be careful. The usual long-term capital gain holding period is more than one year.5 However, to get long-term capital gain treatment for shares acquired via ISOs, the recipient must: (a) hold the shares for more than a year after exercising the options; and (b) sell the shares at least two years after the ISOs were granted.6 The latter, two-year, rule catches many people by surprise.7
Again, when one exercises an ISO, there is no "regular" tax. But there could be an irregular tax, known as the alternative minimum tax, usually abbreviated to AMT.8 As taxes go, it is one of the most hated.
Many people are shocked to find that, even though their exercise of an ISO triggers no regular tax, it can trigger AMT. Note that one does not generate cash when exercising ISOs, because only shares of stock are acquired. If your client owes AMT, he or she will have to use other funds to pay the AMT. Alternatively, one can arrange to sell enough stock when exercising options to be able to pay the AMT.
Example: Alice receives ISOs to buy 100 shares of her employer at the current market price of $10 per share. Two years later, when each underlying share is worth $20, she exercises, paying $10 per share. The $10 spread between her exercise price and the $20 value is subject to AMT. How much AMT Alice pays will depend on her other income and deductions. It could be a flat 28 percent AMT rate on the $10 spread, or $2.80 per share.
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With AMT, clients should run the numbers, and get some advice. If the stock crashes before the holders sell, then they could be stuck paying a tax bill on phantom income. That's what happened to many employees hit by the dot-com bust of 2000 and 2001. In the recent tax reform legislation, the House version of the bill proposed repealing the AMT for individuals. However, the final bill retained the AMT, albeit with temporarily higher exemption amounts.
The other type of stock options are nonqualified options, or NSOs. Because of conditions and limits on ISOs, executives are more likely to receive all (or at least most) of their options as non-qualified options.9 Generally, in fact, NSOs are far more prevalent than ISOs. They are not taxed as favorably as ISOs, but at least there is no AMT trap.
Moreover, NSOs offer some planning possibilities that ISOs do not. As with ISOs, there is no tax at the time the option is granted.10 But when one exercises a nonqualified option, one owes ordinary income tax (and, for employees, Medicare and other payroll taxes) on the difference between the option exercise price and the fair market value of the underlying shares at the time of exercise.11
Example: John receives an option to buy stock at $5 per share when the stock is trading at $5. Two years later, he exercises when the stock is trading at $10 per share. John pays $5 per share when he exercises, but the value at that time is $10 per share, so he has $5 of compensation income for each share exercised. Then, if John holds the stock for more than a year and sells it, any sales price above $10 (his new basis) should be long-term capital gain.
Exercising options to buy stock takes money, and the act of exercising also generates taxes. That's why many people exercise options to buy shares and then sell those shares the very same day. Some stock option plans even permit a "cashless exercise," to cut down on the roundtrip flow of funds.
On the other hand, there's no requirement that a person exercise and immediately sell the acquired shares. In fact, an executive or employee who expects future appreciation in the shares might not want to sell. With an NSO, one can exercise and then hold the shares acquired. One only must hold the stock only for more than a year to get long-term capital gain treatment on any additional appreciation post-exercise.12
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