Employee Stock Option Strategies
A strategy for employee stock options involves timing the sale of acquired stock relative to tax implications. Employers normally grant regular, non-statutory options. But they may provide Incentive Stock Options (ISOs), which have special tax characteristics. In addition, the existence of two tax systems and the possibility of tax assessment upon option exercise are important in strategic planning of employee stock options.
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Paying the Tax
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Income tax is incurred when regular stock options are exercised. Tax is assessed on the “bargain element,” which is the difference between the option exercise price and the market value of the stock on the exercise date. For the exercise of ISOs, nothing is added to income upon exercise of the options. However, the bargain element is included as income under the Alternative Minimum Tax (AMT) system. The income tax liability is withheld from an employee’s paycheck for the effect of exercising regular stock options. There is no withholding for income related to exercise of ISOs. To avoid tax penalties, the employee may be required to make estimated tax payments to the U.S. Treasury. The income tax is payable even if employee compensation is insufficient to cover the tax or the employee is uncomfortable with the degree to which the tax withholding reduces net pay. In such cases, the employee may sell enough of the stock to provide sale proceeds that cover the tax liability.
Stock Price Appreciation
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The strategy of holding stock acquired from exercising stock options is deployed when future appreciation of the stock’s price is anticipated. If the stock is sold more than one year after acquisition, the transaction receives a favorable long-term capital gain tax rate. If the stock’s value increases during this extended holding period, tax assessment on the sale becomes a smaller percentage of the gain. An even more favorable situation arises over time for stock acquired by exercising ISOs. This occurs when the stock is held for over year after exercise and two years after the option grant. In that case, the capital gain is computed as the difference between the sale proceeds and the option exercise price. If both conditions are not met, the transaction is still a capital gain. However, the capital gain is reduced by the amount of bargain element. The bargain element is taxed as ordinary income.
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Stock Price Decrease
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There is a capital loss when the value of stock acquired from exercising options decreases below the market value on the exercise date. The amount of capital loss that is deductible against ordinary income in a single year is limited. Several years may be required for the annual allowable capital loss deduction to offset the tax assessment on the bargain element. Another benefit for ISOs occurs when the acquired stock is sold for less than the market value at the date of exercise. This event is triggered if the sale does not transpire more than one year after exercise and two years after the grant date. The addition to income is not the bargain element. Instead, the only addition to ordinary income is the amount by which sale proceeds exceed exercise price. There is no capital gain.
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References
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