Posting a forward I recieved by email on Taxing of options.
The Basics
To avoid a tax burn, know your (stock) options
Those stock options that made paper millionaires of dot-commers have
turned on many of them with a nasty – and very real – bite. Here’s how
to collect your own options gains without the pain.
By Jeff
http://moneycentral.msn.com/articles/common/bios.asp#Schnepper
Schnepper
In 1999 and into 2000, everybody (except us) was getting rich on stock
options. This year, yesterday’s dot-com millionaires are hemorrhaging
tax dollars on those same options.
If the options problem weren’t so painful, it might be funny. But, for
many people, it is very painful.
Problems can erupt when you exercise your options. The exercise can
trigger a tax hit whose severity depends on the terms of the option
grant.
For one Cisco Systems engineer, the severity was enormous. He exercised
incentive stock options to buy 100,000 Cisco shares in March 2000 at 5
to 10 cents a share. He exercised the options when Cisco was selling at
around $62 to $63. On paper, he was ahead $7 million, and, under the
rules of the Alternative Minimum Tax, he was liable for taxes on the
gain on the day he exercised the options. So, by April 2001, he faced a
$2.5 million tax bill on the shares under the AMT rules, which are
designed to ensure everyone pays some tax. Worse, the value of the
engineer’s shares had fallen some 80%.
Our goal is to help you survive the options quagmire. To do that, you
must understand the different kinds of options and how options work.
Then, if you do get some of your compensation in options, you can start
planning now to limit the tax problem.
There are two kinds of stock options. Those that have special tax
benefits are called Incentive Stock Options (ISOs); those that don’t,
Non-Qualified Options (NQOs). Here’s a summary of how they’re structured
and the benefits you get:
Incentive Stock Option features
Typically granted to: Executives; senior management.
Option price: Must be granted at a price that at least equals the
stock’s market value at the time of the grant.
Taxation
- When granted: None
- At exercise: None, but the spread between the exercise price and
the fair-market value may be subject to the alternative minimum tax. The
logic is tricky, but here it is. Your vulnerability comes into play when
the exercise price of your options is substantially lower than the fair
market value of the shares on the day you exercise. If you fall into the
world of the AMT, the difference between exercise and market price
becomes taxable. If the spread is really large, the AMT can become very
expensive very quickly. So, pay very close attention when you get your
grant and when you exercise the options. - After sale of stock: If you hold your shares for more than one
year after exercise, the entire spread between the sale price and your
cost is a long-term capital gain subject to the maximum 20% rate.
(Capital gains rates weren’t changed under the tax bill passed May 26.)
If you don’t hold for more than one year, you “disqualify” your ISO
shares for long-term capital gains treatment. The difference between the
fair market value at the time of exercise and the sale price is taxed as
ordinary income. If you sell the shares before December 31, you’re not
subject to AMT treatment.
Vesting: May be subject to a graduated vesting schedule or cliff vesting
schedule, according to the terms of the option agreement. A graduated
schedule vests a percentage of the options each year for up to seven
years. On a cliff vesting schedule, the options are all vested at once
after a specified number of years.
Expiration: Typically 10 years following the grant date. Terms may vary
from company to company. Companies are required to disclose the terms of
their incentive option plans to shareholders.
Planning: Remember that incentive stock options can trigger alternative
minimum tax treatment. (The AMT still applies despite a modification in
the new tax bill designed to provide a little relief.) If the value of
the stock subsequently falls, you may still be subject to the additional
taxes the AMT can generate. One way to get around the problem is to sell
your shares by Dec. 31 of the year you exercise your options. Then, your
tax is only on the gain between exercise price and sale price, and it’s
not subject to the AMT. Whatever you do, check with a tax advisor who
knows the tax rules on options before making your move. The wrong move
can be very costly.
Non-Qualified Stock Option features
Typically granted to: All employees in a company.
Option price: May be lower than the value of the stock on the date of
the grant, making it instantly “in the money.”
Taxation:
- When granted: None
- At exercise: Ordinary income tax is due on the spread between
the exercise price and the fair market value of the stock on the date of
exercise. - After sale of stock: In the year of the sale, capital gains
taxes are due on the difference between your cost basis (the fair market
value of the stock on the date you exercise your non-qualified option
and the price at which you sell the stock.) If you sell within one year,
the gain between the exercise price and the sale price is a short-term
capital gain.
Vesting: May be subject to graduated or cliff vesting, under the terms
of the company’s option agreement.
Expiration: Typically 10 years following the grant date. As with
incentive option plans, each company has its own rules on options.
Planning: Remember, your employer reports the gain you realize when you
exercise your options on your W-2 and withholds income and employment
taxes on that amount. Typically, you would pay your employer the amount
of any withholding, along with the exercise cost of your options.
One other stock plan
There’s one more variation on this theme that I see. It’s called the
junior stock plan. This is how it works:
Your employer issues special “junior” non-voting common stock that pays
regular dividends. These shares can be exchanged for regular common
stock, share for share, at a specified date, if the holder meets certain
conditions.
The junior shares are sold to you at a bargain price – for example, $20
when the regular common is trading at $30. You pay income taxes on the
$10 price spread.
At the end of the term, when the regular common stock is trading at,
say, $80, you swap your junior shares for the regular common shares.
On the sale of the regular common stock, you have a tax basis of $30 –
the $20 paid for the shares, plus the $10 on which you were taxed. You
then have a gain of $50 per share – $80 less your $30 basis – which is
taxed at the maximum 20% rate.
Stock options can offer you some great choices and potential for
accumulating wealth. They are intended to provide an incentive for an
employee to continue working for a company. They are not intended to let
you get rich quick.
If you’re lucky enough to receive options, exercise them carefully. The
choices you make – if not made wisely – can cost you plenty. So, think
before you exercise and make the right choice for you.
Best Regards
Nadeem Khan
Softech Worldwide LLC
Phone: +1 703-481-1200
Cell: +1 703 608 0313
Fax: +1 (703)783-0775
email:[email protected]
[email protected]