Equity Compensation Advisor

I recently met with a client who had stock options in Praxair (PX). He called because the options were nearing expiration, and these were the only options he had received from the company.  He wasn’t familiar with how options work, so I explained some of the basics.  His biggest misunderstanding was in the taxability of his non-qualified stock options (NQSQs).  He was granted these options in 2001 when the stock was trading under $20/share. After a 2-for-1 split in 2003, the stock is now trading at over $90/share and he was looking at a large tax bill. 

For NQSOs the bargain element (gain) in options is taxed as ordinary income.  The price of the stock at the time of exercise becomes the new basis of the stock if it is exercised and held, and the holding period also starts on the day of exercise.  Whether the shares are held or sold immediately (cashless exercise), the bargain element will be subject to income tax withholding (federal, state, social security and Medicare).  The amount of this withholding can exceed 40%, resulting in less liquidity than expected.

The tax treatment for Incentive Stock Options (ISOs) gives the executive the ability to convert the bargain element into long-term capital gains—the topic of my next blog.

 Dan’s Moral:  Know the tax implications of the options before they are exercised.

Daniel Langworthy does not provide tax advice.  Please consult a qualified tax advisor.

Securities offered through LPL Financial Member FINRA/SIPC

In my last blog, I discussed how the “AMT Buffer” can allow the executive to exercise incentive stock options (ISOs) without incurring any regular income tax or alternative minimum tax. In this blog, I will show how to determine the number of ISO Shares to sell to use up the AMT Buffer amount.

To find out how many ISO Shares can be exercised without increasing additional tax, we need to know the following three things:

1. AMT Buffer: Difference between the regular tax and the tentative minimum tax (TMT)— discussed in most previous blog.
2. Effective AMT Rate: Depending on income levels, the effective AMT rate can be substantially higher (up to 35%) than the nominal rate (26%-28%), because the AMT exemption is being phased out. One the income threshold is reached, the AMT exemption phases out at the rate of .25 for every dollar of added income.
3. Bargain Element Per Share: Difference between the current stock price and the exercise price. For example, if the ISOs have an exercise price of $25/share and the current stock price is $40/share, the bargain element is $15/share.

With these three pieces of information, we can determine how many ISO shares to sell as follows:

        I.            Divide the AMT Buffer by the effective AMT rate to find the dollar amount of AMT income based on the AMT buffer. For example, if the AMT buffer is $15,000 and the effective AMT rate is 28%, divide $15,000 by 28% ($53,571). This is the amount that can be added to AMT income without increasing the tax.

      II.            Divide the amount from above ($53,571) by the bargain element per share to determine how many ISO shares can be exercised without incurring any tax liability. If the bargain element per share is $15 and the AMT buffer is $53,571, we could exercise 3,751 ($53,571÷$15) shares without incurring any tax liability.

Dan’s Moral: AMT buffer is the secret to exercising the right number of ISO shares to avoid additional tax.

Securities offered through LPL Financial Member FINRA/SIPC