What you need to know about exercising your stock options

If your company is nearing or has recently completed an initial public offering, merger or acquisition, decisions about stock options may suddenly become important, complex and time-sensitive. While options can provide the opportunity to participate in the future growth of the company’s value, they are accompanied by important tax considerations and other nuances that can meaningfully affect outcomes.

Every options holder needs to decide how and when to exercise their options, before those options expire. This article provides a practical overview of how stock options work, how they are taxed and some of the key questions options holders should consider.

At their most basic, stock options are a form of compensation that allow you to purchase company shares at a fixed price, known as the strike price. This price is typically set at the fair market value of the stock at the time the options are granted. Stock options have intrinsic value if the stock’s fair market value rises above the strike price, enabling you to buy the stock at the lower price. Options typically vest over three to four years and often expire ten years from the date of initial grant.

There are two key types of employee stock options used as compensation: non-qualified stock options (NQSOs) and incentive stock options (ISOs). NQSOs are commonly used and can be granted both to employees and non-employees. ISOs are often associated with start-up companies and can only be granted to employees.

The most notable difference between the two types of options is in their tax treatment.¹

• NQSOs: Taxed as ordinary income
  
  When you exercise NQSOs, the difference between the strike price and the fair market value (known as the spread) is typically taxed as ordinary income. If you later sell the shares you acquired, the difference between your cost basis and the sale price is long-term or short-term capital gain or loss, depending on whether the shares are held for more than one year. If your company is pre-IPO, you may need to pay the strike price and any associated tax before you have a liquid market for the shares.

For example: You were granted NQSOs with a strike price of $5 per option. Years after the options are fully vested, your company stock reaches $15 per share and you exercise the options. You pay $5 per share in strike costs immediately. The $10 spread between the strike price and the fair market value is taxed as ordinary income. At that point, your basis is $15 per share and your holding period begins for purposes of determining whether you have long-term or short-term capital gain or loss when you sell the shares.

• ISOs: Eligible for long-term capital gain treatment
  
  When exercising ISOs, the spread is not immediately taxable for regular tax purposes, but it could be subject to the “alternative minimum tax” or “AMT,” a parallel tax calculation that allows fewer exclusions from income, depending on your circumstances (see below). Instead, your gains can be taxed at long-term capital gains rates if you meet certain holding period requirements. To qualify for long-term capital gains tax treatment, you generally must sell the shares more than two years after grant date and more than one year after exercise date. If either holding period is not met, the sale is a “disqualifying disposition,” and some or all of the exercise spread is typically taxed as ordinary income.

For example: You were granted ISOs with a strike price of $5 per option. Years after the options are fully vested, your company stock reaches $15 per share and you exercise the options. You pay $5 per share in strike costs immediately. The $10 spread between the strike price and the fair market value is not taxable under the regular income tax system. However, the spread may be subject to AMT. If you were to wait an additional year and a day and then sell the acquired stock at the same $15 price, the $10 spread and future appreciation is generally eligible to be taxed at preferential long-term capital gains rates. However, the $10 spread at exercise may have been included in income for AMT purposes in the year of exercise. (Exhibit 1)

Incentive stock options and the alternative minimum tax

ISO exercises can result in the payment of the alternative minimum tax (AMT). Each year, you pay the higher of your regular tax liability or your AMT tax liability. In general, the AMT allows fewer deductions and is calculated from a broader income base, but the rate range—from 26% to 28%—is lower than the highest ordinary income tax rate. When you exercise ISOs, the spread is generally not taxable under the regular income tax system at that time. But it is included as income for purposes of the AMT, potentially triggering the AMT for that year.

If you pay AMT because of an ISO exercise, you may generate an AMT credit that can potentially be used in future years when your regular tax liability exceeds your AMT liability. The timing and ability to use the credit depend on your circumstances.  You should consult your tax advisor to determine whether you are subject to AMT.

Practical considerations for options strategies

As you begin to formulate an options exercise strategy, it’s worth asking some key questions.