Over the past several years, we have seen many varieties of equity compensation structures for both C-level executives and key employees at some of the most well-known and successful companies on the West Coast. The Companies we work with encompass publicaly-traded companies who have been publicaly-traded for a long time, those who have recently gone to an IPO and those who are getting close to an IPO. In all of the situations, there are immense opportunities for planning and strategy around minimizing tax liabilities on an annual basis.
Although there are a significant number of combinations that may arise in compensation, we wanted to touch on stock options (ISO’s) in this post. We will have another post next week addressing Restricted Stock Units (RSU’s).
- Stock Options (ISO’s)
Stock options are granted, typically subject to a vesting schedule. The employee/executive is given a certain price to purchase the stock of the Company (option price) that tends to be at a much lower amount that the FMV of the stock. Seems to be a great benefit? Well, yes it is, but there are some considerations that need to be made before exercising those options or selling the stock.
AMT Consideration – When the options are exercised, the difference between the option price and the FMV is added to income for AMT purposes. For example, if you had 5,000 options to buy a stock at $1 per share you would pay $5,000 to exercise those options. If the FMV on that day was $10 per share ($50,000) you would have an addition to income for AMT purposes of $45,000. This could lead to an additional tax bill of $12,600 simply by exercising the options (AMT at 28%). The benefit here is that you do receive a step-up in basis for AMT purposes which means when you sell the stock in the future you will have an adjustment down in your AMT income (planning opportunity!)
Stock Sales – When selling the stock, it may be in your best interest to hold the stock for two years from the grant date and one year from the exercise date to preserve capital gain treatment. This could be significant as there are still long-term capital gains at 15% (depending on your effective tax bracket) whereas ordinary income rates are up to 39.6%. If you don’t meet the holding requirements, the sale will be ordinary income. Remember, when you sell the stock you will have a reduction in AMT as well (see above) so you may consider exercising more options in the same year so you can offset the AMT addition at exercise with the AMT reduction recognized at sale.