There are generally two types of compensatory stock options: Nonqualified Stock Options (NQSO) and Incentive Stock Options (ISO). Economically, NQSOs and ISOs are similar, but their tax treatment is different. NQSOs do not meet statutory requirements for certain tax benefits, while ISOs do, so tax consequences may vary significantly.
Exercising options means purchasing actual shares of the issuer's stock at the price set by the option -- the grant price -- regardless of the stock's fair market value when exercised. When options are granted, there are generally no immediate tax consequences.
When NQSOs are exercised, the spread -- the difference between the stock's fair market value and the exercise price -- is taxable as ordinary income, and the employer is required to withhold both ordinary income tax and FICA tax.
Often, executives sell some of the stock received from exercising the option to cover the exercise price (strike price) and tax liabilities. Economically, this is virtually the same as if the executive had received a cash bonus in an amount equal to the spread.
Because ISOs are granted special tax treatment, executives do not recognize regular taxable income upon the exercise of an ISO. Though this appears to be a huge benefit of ISOs, be aware that you are required to hold the shares for at least one year from the exercise date and could be subject to the Alternative Minimum Tax (AMT). Once you sell the shares, the subsequent stock sale results in a capital gains tax (rather than ordinary income tax) on the excess of the stock's sale price over the grant price.
If you sell the stock before the holding period ends, the shares are subject to a disqualifying disposition, which results in tax consequences similar to the NQSO scenario described above.
An option is not actual stock, but a right to acquire stock. Nevertheless, the option may have significant value and should be managed as a component of your investment portfolio.
If, for example, the issuer's stock price fluctuates significantly or is volatile, it is generally a good idea to exercise options in a systematic manner to take advantage of dollar cost averaging.
Window limitations and option expiration dates are other aspects to consider. Window limitations mean that stock options can only be exercised during a period in which there are no expected company announcements that affect the value of the stock, such as earnings reports, mergers or acquisitions, and new product or technology introductions.
Also, knowing when options expire is critical to executing an exercise strategy that will increase the value of the stocks when sold.
Finally, keep in mind tax considerations. When exercising NQSOs, it is important to ensure that the state tax withheld on the exercise is sufficient to cover the actual state tax liability owed on that income. If not, additional state tax should be paid in the year of the option exercise or there could be a significant AMT consequence.
ISO timing considerations are even more pronounced, both because of possible AMT consequences and the requirement to hold the stock for one year to receive capital gains treatment upon the ultimate sale. All other factors being equal, it may be best to exercise ISOs during the first three-and-a-half months of the year. That allows you to exercise the ISO, hold the corresponding stock for at least 12 months and be in a position to sell the stock at capital gain rates before filing your tax return.
Proactive tax and investment planning helps executives minimize both income taxes and investment risk while maximizing wealth. Christopher G. Sivak, CPA, is a partner with Skoda, Minotti & Co., an accounting and financial services firm that focuses on helping clients grow and develop their opportunities by becoming an integral part of their management team. He has extensive experience in U. S. federal and state taxation. Reach him at (440) 449-6800 or email@example.com.