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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Rounding out our Four Part Series on 83b Elections — let’s explore the preparation of the 83b Election…

As mentioned in my previous blog, the most important thing in making the 83b election is that it must be done within 30 days after the transfer of the shares.  The 30 day period is simply 30 calendar days including weekends and holidays.  There is no specific IRS form required when making the election.  The executive makes the election by filing a statement that includes the specific information indicated in the tax regulations.
(Reg: 1.83-2)

Many of employees may have been furnished with a form been designed by their attorneys.  If a form such as this is not available, you can simply create one for this purpose yourself.  At the top, the document should state:  “Section 83b Election.”  Then begin with the words: “The taxpayer hereby elects under section 83b as follows.”

This form should provide the following information:
•    Name, address, and social security number
•    Description of the shares (3,000 shares of ABC Company).
•    Date the shares were received and the taxable year for which the election is being made.
•    The specific restriction of the stock (example: forfeit is employment terminates before May 1, 2015).
•    Fair value of the share at the time it was received.
•    The amount, if any, paid for the stock.

Tips:

1. I would suggest that the election be sent certified mail and retain the receipt with the date of it.
2. Also, the executive must provide a copy of the election to the company and attach a copy of the election to their tax return for that year.

Dan’s Moral: Check with the company for an in-house 83b election form first and make sure it is filed within 30 days after the shares are transferred.

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This, our 3rd Part in a 4 Part Series on 83b Election risks:

As explained earlier, the 83b Election works great if the shares appreciate from the time the election is filed until the shares vest.  So what are the risks of filing the 83b election?

• Decline in Value:  In last week’s example, if Mary filed the 83b election when the shares were worth $50,000 in 2012, she would report that $50,000 as compensation income on her 2012 taxes.  Fast forward to 2015 — When the shares vest in 2015, and if at the time they are worth only $20,000, the bottom line is that she had paid tax on $50,000 for shares that are only worth $20,000.  If the shares are sold upon vesting Mary would have a capital loss of $30,000, unless she has capital gains from another source, she will only be able to deduct $3,000 of the loss and carry the remaining forward.

Termination of Employment:  In our previous example, if Mary’s employment were terminated, the shares would then be forfeited.  It would seem logical that Mary would get a deduction to offset the income she reported because she filed the 83b election, but the tax code says different.  “If such property is substantially forfeitured, no deduction shall be allowed in respect of such forfeiture.”
Therefore, Mary would get no ordinary income deduction as well as no capital loss deduction.

This rule only applies to a forfeiture of the shares but would not apply if the shares are sold at a loss or is the shares become worthless.

Dan’s Moral:  Understanding the negative consequences if shares are forfeited before they become vested.

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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 Advisor, Member FINRA/SIPC
IRC: 83(b)(1)

In this second edition of my Four Part Series on the 83b Election, I delve into the driving factors that make the 83b Election a good choice for the executive.

As mentioned in Part 1, the executive has 30 days from the date of transfer to make an 83b Election.  Once the election is made, they are treated as receiving the shares at the time of transfer even though they are still subject to a vesting schedule.

You might ask yourself, why would an executive do this?

The main reason would be to have the potential future appreciation taxes of long-term capital gains rate.

Example:   Mary received shares in 2012 valued at $50,000, vesting in 3 years.  If she does nothing, she will not report any income until they vest in the year 2015.  The amount Mary will report will be based on the value when they vest in 2015.  For this example, we will assume the shares are worth $80,000 in 2015.  Mary would report $80,000 as compensation income in 2015 and that would be her new basis for future sales.  Her holding period starts on the day the shares vest to determine whether the share will be taxes as long-term or short-term capital gains.
However, if Mary had filed the 83b election in 2012 she would have reported compensation income of $50,000 in 2012 and when the shares vest in 2015, she would report nothing.  The $30,000 in appreciation would be taxed at the long-term capital gains rate if she were to sell the shares.

As you can see, if the share appreciates, by filing the 83b election the executive can convert the appreciation from compensation income to long-term capital gains rate.

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: Filing the 83b Election has the potential for substantial tax savings but has a fair amount of risk too.

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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

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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•  and Coming Soon:  Individual Case Study examples will be featured.
  

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

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Nonqualified Stock Options
As the series continues, Part 4:  Non-qualified Stock Options are explored as we compare similarities, differences, tax implications, and timing for exercising options.  See example below:

As mentioned in my previous blog, Non-qualified Stock Options (NQO’s) are similar to Stock Appreciation Rights (SAR’s).                                         

What are the differences?   The main difference is that SAR’s provide the holder with the right to receive cash and NQO’s provides the holder the opportunity to by a fixed number of shares at a price determined when the options were granted.

• In summary:   A NQO holder does not report income until they exercise the option.  At the time of exercise, the option holder must pay the exercise price (grant price) and is taxed (compensation income) on the difference between the exercise price and the current price.

Example:

• If the option holder exercised all the options they would report compensation income of $40,000 ($45-$25 X 2,000).
• If the holder is an employee of the company, the income from exercising the option will be subject to withholding and social security tax.

Dan’s Moral:  Because there is no cost or tax implication to the holder at the time the option is granted, options allow the holder to participate in the appreciation of the stock with no cost.

• Please be sure to subscribe to our blog to be automatically notified as the series continues on the “Tax Implications of the Five Types of Equity Compensation, Part 5″. 

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

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

In this five part series we have covered the tax implications of Restricted Stock Grants and Restricted Stock Units.  In part three, we will be discussing the tax implications of Stock Appreciation Rights (SAR).

What are Stock Appreciation Rights:

Stock Appreciation Rights (SAR’s) provide the executive with the right to receive cash in the amount of increase in value of a specified number of shares. The following are some common questions and answers about SAR’s that should help define and differentiate them.

How are SAR’s similar to options:

SAR’s are similar to options in that the executive determines when to exercise the shares.

How do SAR’s differ from options:

Unlike an option, the SAR does not require the executive to come up with the cash at the time of exercise.  By simply exercising the SAR, the executive receives cash.

Note:  However, sometimes companies may grant SAR’s that pay off in shares of the company stock.  By paying off in stock, the company does not need to come up with the cash.

This brings us to the main objective — Taxes:

• SAR’s are taxed the same as non qualified stock options.
• When the executive is granted the SAR or when it becomes exercisable, there are no tax implications.
• At the time of exercise, the executive reports ordinary income on the amount of cash received.
• If the executive receives shares, they will report income equal to the value of the shares the day they are transferred.

Dan’s Moral:  SAR’s provide the executive a way to participate in the appreciation of their company stock without having to come up with money out of their own pocket at the time the SAR is granted, as well as when they are exercised.

• Please be sure to subscribe to our blog to be automatically notified as the series continues on the “Tax Implications of the Five Types of Equity Compensation, Part 4″. 

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

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

Restricted Stock Units; Part 2 of my five-part blog series on the tax implications of the five types of equity compensation:    Restricted Stock Grants, Restricted Stock Units, Stock Appreciation Rights, Non-qualified Stock Option, Incentive Stock Options

 Throughout this series, we will discuss the tax implications of each of the five types of equity compensation first as described in my previous blog published 11/29/2011 (“Five Types of Equity Awards”). 

In my previous blog, Part One of the series, we discussed Restricted Stock Grants, and the tax implications involved.  Part Two consists of defining the second type of equity compensation; Restricted Stock Units (RSU’s), and important components including forfeiture, tax consequences, timing and more.

• Restricted Stock Units (RSU’s) are very similar to Restricted Stock Grants with one exception, the time when the shares are transferred.  Restricted Stock Grants are transferred at the time of the grant even though the executive may not have direct access to the shares due to possible forfeiture based on the vesting schedule.
• In the case of RSU’s the company does not transfer shares at the time of the grant.  The shares are transferred once the employee has worked long enough to meet the required time period.  Fundamentally, the employee would not be entitled to any dividends until the shares are transferred.  Also, due to the fact that the shares are not transferred at the time of grant, the executive cannot file a section 83b election to convert future appreciation of the shares to capital gain. 

Keeping in mind that since the executive does not have access to the shares when granted, there are no tax consequences until the shares are transferred.    At the time of transfer, the shares become vested and the executive will report compensation income on the entire value of the shares.  This amount is the cost basis for tax purposes.

Dan’s Moral:  Because the company determines the timing and restrictions placed on RSU’s, the only decision the executive needs to make is whether to hold the shares at the time of transfer or sell them.

• Please be sure to subscribe to our blog to be automatically notified as the series continues on the “Tax Implications of the Five Types of Equity Compensation, Part 3″. 

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

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