Favorable tax planning opportunities that may apply to your stock options.
- The 2017 Tax Cuts and Jobs Act created additional stock option planning opportunities for corporate executives.
- Of the many recent tax law changes, a few provisions provide expanded planning with respect to incentive stock options (ISOs).
- Making the right decisions when exercising options can make a big difference, so it’s important to discuss the pros and cons of any strategy with your advisors.
A significant portion of a corporate executive’s compensation includes stock options grants. Implementing certain tax-efficient strategies when exercising them can further enhance their value.
Some of the changes in the 2017 Tax Cuts and Jobs Act (the Act) that provide additional planning opportunities for corporate executives (as well as other employees who received stock options from their employers) include:
- Increased threshold of the alternative minimum tax (AMT) exemption phase-out
- New $10,000 limit on the combination of state and local income, real estate, and property taxes ($5,000 for married taxpayers filing a separate return)
- Employees of certain private companies may defer tax on qualifying stock options for up to five years, provided that their stock is not publicly traded and they have a written equity plan covering at least 80% of U.S. employees
Incentive stock options vs. non-qualified stock options
Before delving into the planning opportunities, we first need to define terms and distinguish between stock options that are incentives (ISO) and those that are non-qualifying (NQ). As there is a $100,000 fair market value limit for options to qualify as ISOs, if the fair market value of the stock at the time of the grant exceeds $100,000, those above the limit are NQ.
For example, if a corporate executive receives 1,000 options to purchase the employer’s stock when its market value is $250 per share, the total value is $250,000. Since $100,000 is 40% of the total of $250,000, 400 of the options granted (1000 x 40%) are ISOs and 600 options would be NQ. For the sake of simplicity, we are assuming vesting is immediate.
Strategies to exercise options
With the strategy called “exercise and sell,” the holder is simply doing a cashless exercise for cash, which involves simultaneously exercising and selling the option shares at the current price. The holder receives a check (reduced for payroll taxes and withholdings) for the difference between the grant and exercise prices.
Another typical strategy, “exercising options and holding the shares,” can be accomplished in two ways. The corporate executive can pay the option cost with cash, or it can be paid in shares—a stock swap. With fully vested options, holders can also reduce exposure to concentrated positions by buying “put” options, which provide downside protection, or using a “call” writing program to generate income, which allows additional diversification. However, these strategies ignore what may be significant tax considerations.
A more tax-sensitive alternative is the use of exchange funds: The owner of the shares transfers them into a partnership in exchange for a pro-rata portion of a pool of assets contributed by holders of other option-based shares. Exchange funds are typically available through larger financial and wealth management firms. The benefits include tax deferral (or even tax exemption, if the exchange is structured properly) and diversification. The disadvantages may include a high minimum investment, significant administrative costs, lack of liquidity, seven-year lockup, and passive management.
Private companies and new section 83(i)
The Act added a provision that applies only to employees of privately owned companies who received equity grants in the form of ISOs, NQs, restricted stock units, or purchases via employee stock purchase plans. The shares received upon the exercise or vesting are taxable to the employee, at the time of exercise or vesting, even if they are non-transferrable. This new provision also gives certain employees the opportunity to elect to defer the recognition of taxable income for up to five years when they either exercise stock options or have their stock vest—which would be a taxable event absent section 83(i). Since privately owned company stock is typically illiquid, qualified employees would need to use other funds to pay taxes due upon exercise/vesting; an 83(i) election postpones that need for up to five years. The election can only be made on non-transferrable shares and must be made within 30 days of the first day the employees’ right to the stock is vested or the options are exercised.
Taxation of ISOs vs. NQ
The differences in taxation of ISO vs. NQ are significant, so option recipients should pay close attention to what type of options are being exercised. While neither is taxable when options are granted, NQ are taxable when they are exercised, and as such the difference between the fair market value (FMV) of the stock at the time of exercise and the option price is taken as ordinary income, thus requiring withholding taxes to be held back at the time of exercise. When the shares are finally sold, the difference between FMV on the exercise date and the selling price is a long-term or short-term capital gain or loss. Since most executives have a major concentration in employer stock, most simply treat NQ as a bonus and take cash upon exercise, since the tax treatment is essentially the same as a bonus.
Using our previous example, if after three years a corporate executive decides to exercise the 600 NQ options when the stock’s FMV is $450, the gain of $200 per share, or $120,000, would be taxed as ordinary income, subject to Medicare and Social Security withholding.
When an ISO is exercised, no regular is tax due, which is the major tax benefit when compared to NQ. However, the difference between the FMV and the option price is an add back for the alternative minimum tax (AMT). This results in a difference in the tax basis for regular tax vs. AMT purposes. When the stock is eventually sold, the difference between the selling price and option price is a long-term capital gain for regular tax purposes, if the qualifying holding period of greater than two years after option grant date and greater than one year after exercise date has been met. There is also an AMT adjustment as a result of the difference in the tax basis in shares for the regular tax vs. AMT.
Let’s further assume that the corporate executive also exercises 400 shares of ISOs in the third year, and decides to hold them for two years when the stock price is $600 per share. In the third year, there would be no regular tax due upon exercise, however, the gain, or the “bargain element,” of $80,000 ($450 FMV @ exercise – $250 option price x 400 shares) would be subject to the AMT. When the shares are sold at $600, there would be a capital gain of $140,000 ($600 sale price – 250 basis x 400 shares).
In addition to regular tax, there is a parallel tax calculation with a slightly different deduction, and add backs, one of them being the aforementioned bargain element. Taxpayers pay the higher of the regular tax or the AMT. While the exemptions for the AMT are relatively high when compared to the standard deduction and personal exemptions for the regular tax, there are certain items that are either not deductible (AMT preferences) such as state and local taxes, or are deferral items (AMT adjustment) such as the difference between FMV at exercise date and the option price of ISOs. When the shares are subsequently sold, the preference item is a negative item, reducing the AMT base.
Of the many recent tax law changes, a few provisions provide expanded planning with respect to ISOs. Under previous law, most executives who exercised ISOs were stung by the AMT because of the narrow gap between regular income and AMT income (if one exists at all).
The biggest reason individuals under previous law fell into the AMT is state and local taxes (especially in high tax states like New York and California). With the Act limiting this deduction to $10,000 beginning in 2018, the add back of taxes to the AMT base is maxed at $10,000, providing more room to exercise ISOs without generating AMT exceeding regular tax. Another provision of the Act is the increase in the AMT exemption and the threshold where the exemption is phased out. This also provides additional space between the regular tax and AMT where an executive can exercise ISOs, not paying regular tax and not generating AMT. When planning ISO exercise, avoid unpleasant surprises by doing the math in advance.
Another planning consideration is the change in the federal withholding rate on lump sum payments, which includes NQ stock option exercises. The Act reduced the rate of 25% to 22%. While the decrease in rates provides the executive additional proceeds upon exercise, it also provides a tax planning challenge, as most are in a relatively high marginal tax bracket (up to 37%), meaning the withheld federal taxes would not cover the actual tax liability.
Going back to the previous example where 600 non-qualified options were sold at $450 per share when the basis is $250, the resulting $120,000 gross proceeds would have $26,400 withheld ($120,000 x $22%). If the taxpayer is in the 37% tax bracket, the actual federal taxes due would be $44,400, leaving a shortfall of $18,000. Not only would the additional tax be due, depending on the taxpayer’s situation, there could also be an underpayment penalty if there are not additional withholdings, estimated tax, and payments made—unless the taxpayer qualifies for a safe harbor provision, which is based on the taxpayer’s prior year tax liability. All of this underscores the paramount importance of advance planning with a tax professional.
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