Volume 12 Issue 5

Sept/Oct 2000

© by Tax & Business Professionals

In the last two issues, we looked at the two basic types of stock option programs -- non-statutory stock options (NSSOs) and incentive stock options (ISOs). In this issue, we’ll turn our attention to some of the planning considerations that arise in connection with stock options.

Even though they are governed by different tax rules, ISOs and NSSOs are more similar than they are different. In fact, there are really only two key differences between the two: (1) the exercise of an ISO will never be a taxable event, ignoring the Alternative Minimum Tax (AMT), whereas the exercise of an NSSO will be a taxable event unless the stock is restricted or subject to a substantial risk of forfeiture; (2) if the holding period requirements are met, all of the gain on an ISO will be capital gain, whereas only the gain occurring after recognition of the NSSO gain can qualify as capital gain. To reap the potential benefits of ISOs, however, can require careful planning.

In many smaller or privately held companies, the stock acquired under most options is not transferable or is subject to a substantial risk of forfeiture. Under the NSSO rules, these restrictions can cause recognition of income to be delayed until the restrictions lapse. If the stock is ISO stock, this also means that recognition for AMT purposes of the gain on the difference between the option price and the cost of the option will be delayed until the restrictions on the stock lapse.

The key difference, in such situations between ISO and NSSO stock is the character of the gain that occurs before the restrictions lapse. For the ISO (ignoring AMT), the key can be capital gain if the holding period requirements are met. For the NSSO stock, the gain will be ordinary income, compensation, unless an election is made under Sec. 83(b) to trigger recognition of gain on the exercise of the election. With the ISO, the stock holder is not forced to gamble on a Sec. 83(b) election to maximize the amount of capital gain.

In larger, publicly traded companies, even if it is not formally restricted, option stock may be affected by non-tax limitations on the ability of the holder to sell the stock. Federal and state securities laws or corporate "no trading" policies may limit the ability of a highly placed stockholder to buy and sell the company’s stock. This can create planning dilemmas for stockholders, particularly corporate executives with ISO stock.

If an employee exercises options to purchase ISO stock, he or she may have to pay a significant AMT in the year of exercise. If the ability to sell some of the option stock on the market is limited, the stockholder will need to find other sources of cash to pay the AMT tax.

Planning for the AMT on disposition of the stock is important. In theory, the AMT credit in the year of the sale is supposed to prevent double taxation of the gain that was previously included in AMT. In reality, it may not work that way.

For example, it is possible that in the year in which the stock is sold, other AMT adjustments unrelated to the prior ISO could cause the AMT tax for that year to be the same or larger than the regular tax so that the credit would not be available that year but would carry over indefinitely. Corporate employees who get ISOs every year for an extended period of time, may have to wait many years, perhaps until they retire, to claim the AMT credit on their ISO stock. Sometimes, these problems can be minimized by carefully coordinating the timing of exercises and dispositions of option stock.

Though we never like to think that the value of stock might actually go down, it does sometimes happen. In those situations, great care is needed, particularly with regard to ISO stock, to make sure that gains and losses match up in the right tax period, because otherwise there can be substantial gains in one period that are not fully offset by losses in a later period.

Can S corporations use restricted stock option plans? Despite the "one class of stock" requirement for S corporations, it is possible for S corporations to use restricted stock option plans effectively, if they are correctly prepared. In some situations, however, such plans can create unusual disparities between the federal tax law and state tax or corporate law.

For both employers and employees participating in or considering the adoption of stock option plans, there are potential advantages to be gained by stock options, but careful planning is essential.

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