Equity Compensation Advisor

Part 5:  Five Part ISO Series

During my preparations writing this ISO series, I gathered these final points to  finish up  with a couple of strategies on exercising ISO’s:

1.  The first strategy is to exercise your ISO option up to the AMT buffer amount.  As I had mentioned in my previous blog, if the ISO shares are held through the end of the calendar year at exercise, the option holder will be required to report AMT tax on the bargain element at the time of exercise.  The AMT buffer is the amount by which the option holder’s regular income tax is projected to exceed his tentative minimum tax (TMT).  In this case, the option holder only pays AMT when their TMT exceeds their regular income tax.  Therefore, the AMT buffer can be used to determine how many shares can be exercised without having to pay AMT.

Example:

•     Projected Regular Income Tax: $72,000
•     Projected TMT: $60,000
•     2,000 shares issues: $25/ share
•     Current Price of Stock: $40/share
•     Bargain Element: $15/share ($40-$25)
•     AMT Buffer: $12,000 ($72,000-$60,000)
•     #Shares to exercise with no AMT: 800 ($12,000$15/share)

This is a hypothetical example and is not representative of any specific investment. This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.

2.  The second strategy is based on the timing of the exercise.  As indicated in last week’s blog, if the shares of ISO Stocks are sold before the end of the calendar year, the option holder will avoid any AMT tax liability.  Therefore, it is best to exercise the ISO shares as early in the year as possible so the qualifying sale period starts early in the year.  In addition, the executive will be able to sell their shares by December 31st to avoid AMT tax in case the stock drops substantially.

For a more detailed example, see my white paper on our website “Avoiding nightmares when exercising ISO’s.”

Dan’s Moral: Take advantage of the AMT buffer amount by exercising additional ISO shares without incurring any AMT.

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Part 4: 5 part ISO Series:

As I discussed in last week’s blog, the option holder can either have a qualifying disposition if he plans to hold the shares and take advantage of the special tax rate or he can sell the shares before the end of the year, if the stock goes down in a disqualifying disposition and avoid the AMT Tax.  In this blog I will discuss the effect of AMT on exercising ISOs.

Let’s examine the effects should the option holder hold the exercised shares through the end of the year.   In this scenario, he will be required to report income equal to the bargain element (gain) on the date of exercise for purposes of AMT.  For regular tax purposes, the option holder’s basis in the ISO Stock is the amount he paid to purchase it.  However, under the AMT, the basis of the stock is the amount of income reported in the year of exercise.  In other words, he will have a different basis under the two tax systems.

Example:
Joe exercises an ISO buying $100,000 worth of stock for $40,000.  The following year he sells the shares for $110,000 in a qualifying sale.  Under the regular income tax, he would report a long-term capital gain of $70,000 ($110,000 proceeds – $40,000 paid).  Under the AMT, his basis for the shares includes the $60,000 bargain element ($100,000 – $40,000) he reported as part of his AMT income in the year he exercised.  His capital gain under AMT is only $10,000 ($110,000 – $100,000).

Summary:

This is a hypothetical example and is not representative of any specific investment. This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.

Dan’s Moral:  Understanding the different tax basis for AMT and regular tax could provide significant tax savings.

I hope you have enjoyed this ISO Series.  My final blog (Part 5 of the Five Part ISO Series) will discuss specific strategies on exercising ISO’s.

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This is Part Three of a Five Part ISO Series:

As indicated in Part 1 of the Series, in order to qualify for special tax treatment the option holder has to satisfy the special holding period for a qualifying disposition.  No disposition occurs within two years from the grant date and no disposition occurs within one year after the shares are exercised.  Importantly, both requirements must be satisfied for it to be a qualifying sale.

Example: Joe is granted an option of 5,000 shares with an exercise price of 20/per share on April 1, 2012.  He exercises the shares on May 10, 2016 with a stock price of $50/share.  He had to pay $100,000 (5,000 @ $20/share).  The following year he sells the 5,000 shares at $45/share in a qualifying sale for $225,000 (5,000 @$45).  He would report a long-term capital gain of $125,000 ($225,000 proceeds less $100,000 basis).

The price at the time of exercise is irrelevant for regular tax purposes.  However, the value is important in determining the alternative minimum tax.

In the above example, if the options were non qualified, the option holder would have been required to report $250,000 (5,000@ $50/share) of compensation income when he exercised the shares for the tax year 2016.  This additional income would also be subject to tax withholding and social security.  Further, if he held the shares for 12 months and sold them for $45/share ($225,000) he would have a capital loss of $25,000 on the sale.  Unless he has capital gains to offset the loss, he is limited to a $3,000/year deduction.

With ISO’s , the option holder can use the income limitation rule that would permit him to make a disqualifying disposition of ISO shares and report compensation income only on the actual profit.

Example: In the previous example, when Joe exercises his shares at $50/share on May 10, 2016, if he sells at $40/share in December of that year he will only report the actual gain of $100,000 ($100,000 exercise (basis) proceeds $200,000) and would avoid any AMT tax.

These are hypothetical examples and are not representative of any specific investment. This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.

My Next blog (Part 4 of the Five Part Series)  will discuss how AMT effects the exercise of ISO’s.

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This is Part 2 of 5 in a Five Part ISO Series

Sometimes it is not always clear whether the option is a non qualified option or an ISO.  For an option to qualify as an ISO it must meet four requirements:

1.   The exercise price of the option cannot be lower than the value of the stock when the option is granted.
2.   The term of the option cannot be longer than ten years.  However, the option can be shorter but not longer than ten years.
3.   The option cannot be transferable except at the death of the option holder.  Once the option has been exercised, the stock may be transferred but not the option itself.
4.  If the option holder owns more than 10% of the voting stock in the company, the exercise prices of the option has to be at least 110% of the value of the stock when the option was granted and the term of the option cannot exceed five years.                                                             Lastly, the option holder must have been an employee of the company at the time the option was granted (as opposed to an outside consultant or director).  Also, the option holder must exercise the option while they are still employed by the company or within three months after their termination date.  However, if the option holder is disabled, the favorable tax treatment is extended for one year versus three months following termination of employment.

My next blog (PART 3) will focus on the Tax Treatment of ISO’s

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This is Part 1 of 5 in a Five Part ISO Series

Definition:  Incentive Stock Options (ISO’s) are options that meet certain requirements that are eligible for favorable tax benefits.
The main benefit is the ability to convert the bargain element (gain) from regular income to long-term capital gain.  In order to take advantage of this tax benefit, the option holder is required to hold the shares after exercise for a specific period of time, exposing them to additional concentration risk.

Additionally, the option holder is subject to alternative minimum tax (AMT) in the year they exercise the options exposing them to additional tax risk.

** Most executives don’t take full advantage of exercising ISO’s to minimize tax — Why? Between the concentration risk, the AMT risk, and the complexity of putting together a sound strategy generally prove good reason for missing out.

The tax benefits of ISO’s over non qualified stock options are as follows:
•    For regular tax purposes, the option holder reports no income at the time they exercise the ISO.
•    If the shares are held long enough after exercise, any profit from the sale of the shares are taxed at long-term capital gains rate.
•    If the shares are not held long enough to avoid a disqualifying disposition, the option hold may be able to limit the amount of income to the actual profit from the date of exercise.
•    The profit from the exercising an ISO or selling the shares is not subject to tax withholding or social security tax.

Disqualifying Disposition:  This is a disposition of shares that occurs before the special holding period requirements.  To avoid a disqualifying disposition, the option holder must meet both of the following requirements:
•    No disposition occurs within two years from the grand date of the option.
•    No disposition occurs within one year after the option has been exercised.
If both of these holding periods are met the sale is considered a qualifying sale.

Part II of the Series will discuss the qualifications for an option to be an ISO.

Dan’s Moral: Taking advantage of the special tax treatment for ISO’s requires an overall understanding of the tax structure but could be a tremendous tax savings.

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Taxation of Incentive Stock Options – ISO’s
In this, my fifth and final submission to the blog series on the taxation of different equity awards, we examine the “Taxation of Incentive Stock Options” or ISO’s, the benefits and tax implications.

Tax Benefits:  Holders of ISO’s are eligible for certain potential tax benefits that are not available in the previously discussed equity awards.  The main tax benefit of ISO’s is the ability to convert compensation income into long-term capital gain.   In order to qualify for the long- term capital gain rate, the option holder must hold the stock for a specified period of time after exercise.

There are four tax benefits of ISO’s over other equity awards:

1.  At the time of exercise, the option holder does not report any income for regular tax purposes.
2.  If the option holder holds the shares long enough to avoid a “disqualifying disposition” (for future blog discussion) the bargain element (gain) will be taxed as long-term capital gain.
3. The bargain element from the exercise or profit from the sale is not subject to income tax withholding or Social Security tax.
4. If the shares are sold in a disqualifying disposition, they may still be able to limit the amount of income reported to the actual profit from the purchase and sale, versus a non qualified option that must report the actual gain at the time of exercise.  This applies regardless if the shares drop in value after the exercise.

So exactly what are the potential tax implications when ISO’s are exercised?  In most cases an option holder who exercises an ISO, and holds the shares beyond the end of the year of exercise, will be subject to AMT tax.

Dan’s Moral: ISO’s give the option holder the ability to convert the gain into long-term capital gains if the proper strategy is used.

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For more information on Dan Langworthy and Executive Capital, LLC you can also visit our website: http://www.executivecapitalmn.com and view Dan’s profile on Linkedin http://www.linkedin.com/in/danlangworthy

Securities and advisory services offered through LPL Financial, a Registered Investment Advisory, Member FINRA/SIPC

As I had indicated in my November 2010 blog, it is normally preferable to exercise ISO shares early in the year to start the one-year holding period to qualify for the long-term capital gain rate.

This blog will explain the reason behind the early exercise and the impact on AMT (alternative minimum tax). The primary advantage provided by ISO shares is the ability to have the bargain element (gain upon exercise) taxed as a long-term capital gain instead of as ordinary income.

Currently, the long-term capital gain rate is less than half of the top marginal tax rate, so the tax savings is substantial. In order to be eligible for the ISOs to be taxed at a long-term capital gain rate, the option holder must meet both of these requirements:

1. No disposition occurs within two years from the option grant date.
2. No disposition occurs within one year from when the option is exercised and transferred to the option holder.

When these two criteria are met, the bargain element is taxed as a long-term capital gain. This special holding period is often referred to as a qualifying sale.

The second requirement—shares from exercise must be held for a year—is challenging. The bargain element is subject to AMT in the calendar year of exercise. If the value of the shares was to drop substantially before the one-year holding period ends, the option holder may own shares that are worth less than the AMT tax liability. There lies the rub.

The question becomes: “How do I obtain a long-term capital gain rate after exercising my ISO shares without the added risk of the shares going down?” The answer is: “Exercise ISO shares as early in the calendar year as possible.” The tax code indicates that if ISO shares are sold before the end of the calendar year in the year of exercise, the bargain element would be subject to ordinary income and the AMT would be eliminated.

By exercising ISOs early in the year (January, February), the exposure of the stock dropping substantially to meet the one-year holding period is only a month or two versus six months or longer for ISOs exercised in June or beyond.

Dan’s Moral: The early ISO exerciser gets a head start on the special holding period and is ahead of the game.

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

Securities and advisory services offered through LPL Financial, a Registered Investment Advisory, Member FINRA/SIPC