Year-end Planning: Clients Holding Employee Stock Options

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Robert Trinz
Senior Analyst
Thomson Reuters Checkpoint
Columnist
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It is likely that many your individual clients hold employee stock options and there are several considerations for them in light of current Congressional efforts at tax simplification and tax rate reduction, which, if enacted, would most likely be in effect for 2018.

Employee stock options are contracts giving employees the right to buy the company's common stock at a specified exercise price after a specified vesting period (e.g., two to four years). The exercise price is typically the market price of the stock when the option is granted (although it can be higher or lower), and the option is usually exercisable for a certain period (e.g., five or ten years).

When the exercise price of the stock is less than the stock's fair market value (FMV), the option is said to be "in the money" and worth exercising. When the exercise price of the stock is more than the stock's FMV, the option is said to be "out of the money" and not worth exercising.

Here are two main types of employee stock options and tax planning tips specifically for your clients that hold them:

1. Incentive Stock Options (ISOs)

An ISO, which is a form of qualified stock option, is granted to an employee by an employer to buy stock or ownership interests in the employer. (Reg. § 1.421-1(d)(3), Reg. § 1.421-1(i)(1)) There are no regular income tax consequences when an ISO is granted or exercised; the employee has capital gain if the stock is sold at a gain. (Code Sec. 421(a)); FTC 2d/FIN ¶ H-2750)

An ISO must meet various requirements. (Code Sec. 422(b)) For example, the option price must be no less than the market value of the stock at the time of the grant, it must be exercised within ten years from the time of grant, and the market value of the stock for any ISOs exercisable in any year is limited to $100,000 for any individual.

To qualify for favorable treatment, stock acquired through the exercise of an ISO generally can't be disposed of within two years after the option is granted or one year after the stock is transferred to the employee. (Code Sec. 422(a)(1)) Also, for the entire time from the date an ISO is granted until three months (one year in case of an employee with a total and permanent disability) before its exercise, the option holder must be an employee of the option grantor (or its parent or subsidiary or certain successor corporations). (Code Sec. 422(a)(2), Code Sec. 422(c)(6))

An employee who meets the dual holding periods won't recognize income as a result of exercising the ISO. (Code Sec. 421(a)(1)) If, after holding the stock for more than one year, he or she sells at a gain the stock acquired by exercising the ISO, all of the gain will be favorably-taxed capital gain. But, under current law, the gain also would be subject to the 3.8% Medicare surtax.

If there is a disqualifying disposition of a share of stock, Code Sec. 421 does not apply to the transfer of the shares. Instead, the exercise of the option is governed by Code Sec. 83 and its regs. Thus, in the tax year in which the disqualifying disposition occurs, the individual recognizes ordinary compensation income (and gets a basis increase) equal to the bargain element—that is, the FMV of the stock on the date the stock is transferred less the exercise price (determined without reduction for any brokerage fees or other disposition costs).

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About Robert Trinz

About Robert Trinz

Robert Trinz is a senior analyst with Thomson Reuters Checkpoint within the Tax & Accounting business of Thomson Reuters.

 

 

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