CCH-JOURNAL, TAXES-MAG Taxes--The Tax Magazine, October 1999, FAMILY TAX PLANNING FORUM--The ABCs of ISOs and NQSOs
FAMILY TAX PLANNING FORUM--The ABCs of ISOs and NQSOs

©1999 CCH INCORPORATED

By Robert S. Keebler

Robert S. Keebler, CPA, MST, is a shareholder with Schumaker Romenesko & Associates, S.C., Family Wealth Preservation Team, in Green Bay, Wisconsin.

One of the more perplexing issues facing tax advisors is the challenge of when to exercise qualified and nonqualified stock options. In today’s highly competitive environment, more and more companies are offering stock options to employees. There are two separate types of stock options: nonstatutory “nonqualifed” (NQSOs) and the qualified statutory “incentive” (ISOs) stock options. Incentive stock options are simply options granted under the provisions of Code Sec. 422(a)  while nonqualifed stock options are a creation of financial design, not congressional grace.

In general, most executives will have more NQSOs than ISOs. This occurs because of statutory limitations imposing a $100,000 annual limitation on the value of ISOs granted.

The most important financial component is the high degree of leverage in most option plans. In most instances, a taxpayer can have the financial benefit of owning a large number of options (i.e., tremendous upside potential) while having very little capital at risk.

Table 1 provides a refresher on the income taxation of qualified and nonqualified stock options.

Table 1

Event              ISOs                          NQSOs

Grant of option    No income is recognized upon  Generally, not taxable.
                   the granting of an ISO. Reg.  However, where the option has
                   §1.83-3(a)(2)                 a readily ascertainable fair
                                                 market value, the grant is
                                                 taxable. Code Sec. 83(e)(3);
                                                 Reg. §1.83-7(b)(3).

Exercise of option Generally, not 1  taxable     Upon exercise, ordinary
                   upon exercise. Code Secs.     income will be recognized.
                   421(a) and 422(a). However,   The amount recognized is the
                   an alternative minimum tax    difference between the fair
                   (AMT) item adjustment must be market value at exercise and
                   made for the spread between   the amount paid for the
                   the option price (“strike    stock.
                   price”) and the fair market
                   value. Code Sec. 56(b)(3).

Gift of option     N/A 2                         An original option holder
                                                 does not recognize income
                                                 upon transfer. 3 

Sale of stock      If disposed of after the      Capital gain is recognized
                   statutory holding period, 4   for the difference between
                   the employee will recognize   the sale price and the basis
                   capital gain treatment on the of the stock.
                   difference between the amount
                   realized on the sale versus
                   the exercise price. Code Sec.
                   1001(a). Negative AMT
                   adjustment to recapture prior
                   positive AMT adjustment.

Nondiversified Portfolio

Generally, an employer will grant options on an annual basis, which begin to vest in two to 10 years. In many instances a complex analysis may involve both NQSOs and ISOs that vest in a variety of years. The decision of when to trigger stock options is a question well beyond the tax implications; it is a holistic analysis of the leverage intrinsic in the options, the method (s) of converting the options, the client’s current tax situation and the financial stability of the company. In many instances a client may have over 40-60 percent of his or her net worth represented by the value of the stock options. From an overall financial and tax perspective each series of options must be viewed both separately from a timing perceptive and on an overall basis from an investment viewpoint. The starting point of an overall strategy should generally be asset allocation modeling and an objective analysis of the financial stability of the company. In many instances an approach that merely contemplates the tax effect will illustrate when to exercise options while ignoring the possibility that holding additional stock may represent too much risk for the client. 

Example: Dave has 20,000 common shares of the internet company volitale.com. These shares are currently valued at $100 a share for a total value of $2,000,000. Dave also has 10,000 NQSOs to buy additional shares at $10 a share. These options expire in eight years. In addition, Dave has a home worth $350,000 and a cash sum of $500,000. If Dave wanted to buy the stock he would need to invest $100,000 and pay income taxes on the $900,000 ([$100 FMV - $10 strike price] x 10,000 shares), the difference between the fair market value and strike price. Upon exercise and ignoring payment of tax, Dave’s asset portfolio now is comprised of 78 percent of volitile.com stock. Beyond the mere taxation and upside potential of the option stock, Dave must also consider the downside potential of this non-diversified portfolio.

Exercising ISOs Generates AMT

The Alternative Minimum Tax (“AMT”) is a separate and distinct tax system that requires taxpayers to pay the greater of the calculated liability under the AMT system or the regular tax system. Each of these systems has defined items recognized as deductions, and similarly, certain items will be recognized as income. The exercise of an ISO does not create current income under the regular system. However, the exercise creates an AMT adjustment equal to the spread between the option price and the fair market value of the option stock. 5 

When a taxpayer is subject to the AMT system, the first $175,000 of AMT income is taxable at 26 percent, while amounts in excess of $175,000 are taxable at 28 percent. 6 Where an individual pays AMT instead of the regular tax, an AMT credit is generated. However, the AMT credit is available only where the tax is the result of timing issues. The credit is not available for permanent differences, such as state taxes paid and the taxpayer’s personal exemption. Therefore, AMT may result in a higher effective tax rate. The AMT credit may be used to offset future regular tax liabilities.

The ISO spread has been taxed at a rate of 26 or 28 percent for AMT purposes, yet the option stock will generate a 20 percent capital gains tax upon sale. Therefore, a taxpayer in effect may be prepaying taxes for a future credit that may be absorbed upon sale of the option stock. Thus, care must be exercised in the structuring of ISO exercise and planning for the full use of the AMT credit. 

Example: Ben, an executive with Big Co., has been granted 2,000 ISOs with an exercise price of $50. Several years later, Big Co. reaches $85 per share. Ben exercises his options. While no regular income is recognized, Ben will recognize an AMT adjustment of $70,000. To the extent that an AMT credit has been generated, any future regular tax in excess of AMT will be reduced by the AMT credit. When Ben ultimately sells Big Co. stock, Ben will receive capital gain treatment and further will receive a credit for AMT tax previously paid.

In addition to planning for maximum use of the AMT credit, the AMT itself can be minimized through the exercise of NQSOs. The exercise of NQSOs will result in the recognition of ordinary income to the extent that fair market value at the date of exercise exceeds the option price. In creating additional ordinary income taxation at a higher marginal tax bracket, one reduces the likelihood of AMT exceeding ordinary income tax. This computation will be driven substantially by the option holder’s marginal tax bracket and the expected growth rate of the stock. Generally, the higher the expected growth rate, the more likely it is that exercising NSOs will be in a client’s best interest. 

Financing Exercise Costs

Exercising stock options requires a cash outflow. One has the following options with regard to the option exercise:

l One may use cash to exercise the options;

l One may obtain a margin loan to exercise the options;

l One may use existing stock (“stock swap”) to exercise the options; or

l One may replicate the stock swap option resulting in “pyramiding.”

Cash serves as the simplest mechanism to fund the option exercise. Some corporations will assist executives by granting what is known as a “double bonus.” In essence, a double bonus is calculated to equal the option exercise amount as well as the related tax generated due to the bonus.

It may make sense to obtain a loan to pay for the exercise of the options if the cost of obtaining the loan is less than the expected growth of stock. Therefore, if the cost of the loan is less than the expected growth of the stock, a loan to pay for the exercise should be evaluated. One must also consider that securing a loan may be very costly to the option holder, as the price may fluctuate resulting in margin calls or the liquidation of other securities.

It is also possible to finance the cost of exercising the options with existing stock in a stock swap. 7 One must review the option agreement to ensure that this technique is available under the agreement. This technique involves exchanging shares that one owns for the payment of the exercise price and thereby, new shares of stock. 8 Where this technique is used, one acquires a basis in an equal number of new share in an amount equal to the to the original basis. Additional shares receive a basis of zero.

The stock swap option can be replicated resulting in a “pyramiding” of future exercises with stock acquired from previous exercises. Pyramiding can only be used for NQSOs due to the requisite one year holding period for ISOs. 

This technique is illustrated by the following example (see Table 2): Joe, an employee of Widget Co. owns one share of Widget Co. he recently purchased at $50. Joe has also been granted 62 options to purchase additional shares at $25 per share.

Table 2

                    FMV of
     Option Shares  Shares   Options
Step Price  Swapped Swapped Exercised

 1    $25       1    $  50       2
 2    $25       2    $ 100       4
 3    $25       4    $ 200       8
 4    $25       8    $ 400      16
 5    $25      16    $ 800      32

Through the use of Joe’s single share, he is able to exercise all 62 options, although he must also be mindful of the income tax liability of the exercise.

Conclusion

Planning with stock options requires weighing many complex factors and considerations. This analysis requires a thorough understanding of the income tax implications of action and inaction. In order to achieve the optimal result for a client, this will often require a series of multi-year income tax projections and elaborate crossover modeling to determine the year and amount of exercise under a series of prospective growth rates.