Ø How is a nonqualified stock option taxed?
If a NQSOs FMV can be readily determined (such as when the option is traded on an established market, which is not common for employer stock options), the option is taxed to the employee as compensation at the time it is granted. If the FMV cannot be readily determined, the employee recognizes compensation when the option is exercised. The amount included as compensation is the difference between the amount paid for the stock and the FMV at the time it becomes substantially vested. The amount included in income increases the basis in the stock.
The holding period for the stock starts on the date after exercise. Appreciation on the stock above the FMV on the date of exercise is taxed as short-term capital gain if the stock is sold within one year or less from exercise, and long-term gain if sold more than one year from exercise. If the stock depreciates in value, the loss upon disposition is treated as either short term or long-term capital loss.
Ø My client exercised and sold nonqualified stock options. Why did the Form 1099-B show the net sales proceeds if the bargain element is already reported on the client’s W-2?
For stock acquired by exercising a nonqualified option, the basis shown on Form 1099-B will generally be incorrect. On Form 8949 in column (e) you’ll show the basis reported by the broker, even though you know it’s incorrect. In column (f) you’ll write BO, codes indicating that the broker reported incorrect basis, and that the reason was “other.” In column (g) you’ll show the amount of adjustment to gain or loss that’s needed to arrive at the correct result.
In the usual case, the basis reported by the broker is incorrect because the adjustment for income reported on exercise of the option is omitted. This is a positive adjustment to basis, but the form calls for an adjustment to gain or loss. Basis is subtracted to determine gain or loss, so this is a negative adjustment, which should be shown in parentheses.
You should also attach a statement explaining the adjustment, like this:
Form 8949, sale of XYZ stock, broker failed to adjust basis for compensation income reported on exercise of compensatory option.
Ø What are incentive stock options (ISOs) and how are they taxed?
Incentive stock options receive preferential tax treatment and are referred to as statutory stock options. If requirements are met, stock purchased with a statutory stock option produces a capital gain or loss when sold. This shifts employee compensation from ordinary income to capital gain in the amount of the stock’s appreciation.
When an employee exercises the option, there is no tax liability for regular tax purposes (See next question for taxation under AMT). When the stock is sold the difference between the FMV at sale and the strike price will be taxed as a capital gain. FICA taxes are not assed upon the exercise of a statutory stock option or the qualifying or disqualifying disposition of stock acquired by the exercise of a statutory stock option.
To receive this preferential tax treatment the employee must hold the stock for at least two years from grant and one year from the exercise date. If an employee sells the stock without meeting these requirements it is considered a disqualifying disposition. In this case, the FMV at time of exercise minus the strike price will be taxed as ordinary income and any remaining gain will be taxed as a capital gain.
Ø What is the effect of exercising an ISO for AMT?
**Important Note: Exercise of ISOs are one of, if not the main reason individuals will be subject to AMT**
Although the spread between the FMV at time of exercise and the strike price is not taxed in the year of exercise for regular tax purposes, it is an add-back for AMT. If the employee is subject to AMT tax due to exercising the ISO, a situation arises where there would be a dual basis in the stock, one for regular tax (strike price), and one for AMT (FMV on date of exercise). Since the bargain element will also be subject to regular tax as capital gain when the stock is sold, the AMT tax due to the ISO exercise may be recaptured in future years through the Minimum Tax Credit on Form 8801.
The AMT tax from an exercised ISO can be used as a credit against regular tax in any qualifying year following the year of exercise. The ISO stock does not need to be sold before the credit it used. The credit can be used when AMT tax is lower than regular tax. The amount of the credit is limited to the lesser of the amount by which that regular tax exceeds AMT, or the amount of AMT tax incurred from exercising the ISO. If only part of the ISO AMT tax can be used towards the credit in one year, the remainder may be carried forward into future, qualifying years until used or the taxpayer dies.
Ø What is a disqualifying disposition on an ISO and what are the tax consequences if it occurs?
A disqualifying disposition means the stock was sold within 2 years from grant and/or one year from exercise of the option. In this case, the ISO loses its preferential tax treatment and the FMV at time of exercise minus the strike price will be taxed as ordinary income and any remaining gain will be taxed as a capital gain.
Basically, the ISO follows the rules for NQSOs upon a disqualifying disposition.
Ø Must employment taxes (FICA) be paid on the exercise of incentive stock options?
FICA taxes are not assessed upon the exercise or the qualifying or disqualifying disposition of an ISO.
Ø What is the $100,000 per year limit on incentive stock options?
An option that otherwise qualifies as an ISO fails to be an ISO to the extent that the $100,000 limitation described next is exceeded. To the extent that the aggregate FMV of stock with respect to an ISO is exercisable for the first time by the individual during any calendar year exceeds $100,000, such option is treated as a nonstatutory option. The rules pertaining to the above limitation are as follows:
1. The FMV of the stock is determined as of the grant date of the option
2. The options are taken into account in the order in which they are granted
3. An option is considered to be first exercisable during a calendar year if the option will become exercisable at any time during the year.
Ø Explain a cashless exercise and the income tax implications thereof?
With a cashless exercise, the employee elects not to pay for the stock upon exercise of the option. Instead they decide to just take the spread between FMV at exercise minus the strike price as a cash payment. The employee is still taxed as ordinary income on this spread between FMV at exercise – strike price.
For example, an employee has the option to exercise an option to buy his company stock at $40 per share. The stock is currently trading at $70 per share. If the employee exercised the option and wanted to keep the stock he would have to pay $40. Instead the employee elects a cashless exercise and instead of receiving stock, receives $30 in cash which is the difference between FMV and strike price. This option is best for people who don’t have the funds available to purchase the stock.
Ø Explain a swap stock and the income tax implications thereof?
If the company allows for it, employees may use shares they already own outright to pay for the cost of exercising stock options. This is known as a stock swap since shares of old stock are being swapped out for an equal number of new stock, plus additional shares.
The FMV of the old stock can be used to pay for the cost of the strike price of exercising stock options. You get credit for current value on the old shares you turn in, which is higher than the option price for the new shares you receive in the exchange, which results in the acquisition of additional shares. The basis and holding period of the old stock carries over to the same number of new shares from the exercise. Additional new stock acquired will have $0 basis (before any compensation adjustments) and a holding period that begins the day after exercise.
Example if NQSO is exercised:
Jack Smith owns 100 shares of ABC, his employer, with a tax basis of $10 per share and a current fair market value of $100 per share. Jack also has a vested NQSO grant allowing him to buy 400 shares of ABC at a price of $25 per share.
Jack doesn’t have the $10,000 he’d need to exercise the option grant. Rather than selling the 100 shares he owns to generate the cash, Jack can deliver those shares as payment. The benefit here is that he doesn’t have to pay the $90-per-share capital gain he would have otherwise incurred if he had sold the shares versus swapping.
In this scenario, Jack would end up with 400 shares of ABC—100 shares with a carryover basis of $10 per share and 300 shares with a basis of $100 per share. The shares used in the swap maintain their original basis and holding period. The other 300 shares have a basis of $100 because, upon exercising the NQSO grant, Jack must pay ordinary income tax on the difference between the grant price of $25 and the fair market value of $100. The income tax payment on the $30,000 proceeds sets the basis on the non-swapped shares at $100 per share.