Re: Income Tax Consequences of Exercised Options

From: Rich Carreiro <rlcarr@animato.pn.com>
Subject: Re: Income Tax Consequences of Exercised Options
Date: Wed, 3 Feb 1999 16:09:27 -0500

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>My sister just informed me that this past December she and her husband 
>decided to exercise some company stock options her husband had been 
>given a few years ago by his employer.

What kind of options are they?  The tax treatment is massively different
between incentive stock options (ISOs) and non-qualified (or non-statutory)
stock options (NQOs).

>Now my sister is concerned because she has reviewed the relevant 1998 
>income tax publications and believes that she and her husband will be 
>required to pay about $9000 in 1998 income taxes on the difference 
>between the exercise price of the options and the (sky high) market 
>value of the stock on the date of exercise, despite the fact that the 
>stock has not actually been sold,

If they are non-qualified options, she is correct.  The spread between the
exercise price and the stock price on day of exercise is wage income, subject
to income tax, Social Security tax, and Medicare tax.  Her basis in the shares
for future gain/loss is the stock price on day of exercise.

If they are ISOs, no regular tax is due on the spread, though the spread is
an Alternative Minimum Tax preference item, and gain will only be realized
when the stock is ultimately sold.

>on the date of exercise.  Is she correct?

If they are NQOs, yes, she is correct.

>If so, are they at least 
>entitled to the lower long term gains rate because they held the options 
>for longer than one year?

No.

> Is there any way they could have handled this 
>matter differently which would have allowed them to defer realization of 
>"profits" from the option exercise until the acquired stock was sold, 
>thus avoiding a big tax bill this April?

If they are NQOs, no.

>At this point, would it be 
>possible to sell an equivalent amount of stock borrowed from their 
>broker in order to raise immediate funds to pay the tax due?

Once they own the stock, they can do what they want with it, subject
to any rules (such as trading blackouts) the company imposes on them.

>this course of action have the desired effect of entitling them to the 
>long term capital gains rate for profits resulting from the eventual 
>liquidation of the current shares of stock?

If these are NQOs, holding period begins the day after the option is
exercised.  However, nothing you do with the stock can change the
character (which is ordinary income) or amount of income realized by
the option exercise.

Rich Carreiro
rlcarr@animato.pn.com
P5-100/RedHat Linux 4.2

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