STOCK OPTIONS AND CAPITAL GAINS:
(SF Chronicle, 1999, Robert Summers)
An option is the right to buy (or in more complex options, the right to sell) a certain number of shares of a company for a certain price in the future. The option holder pays "$X" and the amount considers numerous variables.
These fall under IRS Code 421 through 424.
Normally the receipt of an ISO or option is NOT a taxable event nor is the employer granted a deduction (at that time).
INCENTIVE STOCK OPTIONS (ISO):
When to Exercise- wait at least a year after the company grants the option so you can get the lower capital gains rate. Otherwise the difference between the exercise price and the market value will be subject to ordinary income tax rates
The option price cannot be less that the Fair Market Value of the stock at the time the ISO is received and it must be exercisable within 10 years from receipt. Additionally, an employee cannot own more than 10% of all classes of stock of the parent company or subsidiaries.
When to Sell the Stock
Once an ISO is exercised, he may be taxed as LTCG as long as he does not sell the stock fair at least two years after the option was granted and one year after exercising the option. An employee must remain employed by the company from the time the option is granted till at least three months before exercise. An EE also has three months after termination to exercise an ISO.
If these limitation are not met, the gain is taxed as ordinary income, determined at the time the option was exercised. The gain is usually the value of the stocks on the date of exercise minus the option price. The employer is entitled to a deduction at the time th eE recognizes the income from the premature disposition.
STOCK PURCHASE PLANS
If the option prices is not less than 85% of the Fair Market Value when acquired, or at the time of exercise, then normally the difference between the option price and the FMV at the time of grant is treated as ordinary income.
NONQUALIFIED STOCK OPTIONS
When to Exercise the Option
Quickly, before the price goes to high. That might look odd since the difference between the exercise price and the market value is taxed as ordinary income. But then it can grow and be taxed at capital gains rates. This is an IRC Sec 83(b) election
Wait at least 12 months- you get capital gains rates at 20%.
ALTERNATIVE MINIMUM TAX
The difference between the stock value and the option prices is an "plus" adjustment under the AMT rules.
NON STATUTORY STOCK OPTIONS:
With these options, an Employee is taxed when
1). the option is received
2) when the option is exercised and
3) when restrictions (if any) on disposition of the stock (acquired by the option) cease.
NON QUALIFIED STOCK OPTIONS AND CHARITIES: (Ticker 2000) If non qualified options have come due and have become more valuable (the whole idea), you are subject to ordinary income tax (not long term capital gains) between the exercise price and the current market value. That can be a substantial hurt. You might transfer the cash received to a charitable lead trust (you gift the income generated from the new investments and get the assets back at a later time). You should use tax free funds/investments since the income is still taxed to the grantor. The grantor receives a tax deduction based on the amount of the income stream, for how long and at a rate determined by the IRS. The deduction can be used to offset the tax from the exercise of the options.
Concise article on negotiating stock options (2000)