What Are Your Stock Options?
The Henssler Financial Group Position Paper

Start-up companies and companies that are merging or buying other businesses are more often hiring and retaining employees by awarding stock options. For many employees, it commonly feels like winning the lottery. For example, let's say your company has just been bought out by another high-tech, well-known Internet company.

For employment incentive, you have received the option to purchase stock in your company at very little cost and sell it at market value. This feels better than Ed McMahon showing up at your door.

Now what—you feel rich, but do you rush to buy stock as soon as you are vested at this bargain price and sell it?

Okay, hold on and slow down. Before you jump in and exercise your rights to buy the company stock, let's see how much cash you end up with after buying the stock and paying taxes.

First, and possibly most importantly, what kind of stock options are they? This question is critical as to how the options are accounted for and how they are taxed.

The two most common types of stock options are: Incentive Stock Options (called ISOs) and Nonqualified Stock Options. These two types are treated very differently on your annual tax returns and differ greatly in the amount of tax owed because you have exercised your rights to buy the stock options.

When you exercise Nonqualified Stock Option—which is when you purchase the company stock at your grant price—you recognize ordinary income equal to the difference between the fair market value of the company stock on the date you exercise your shares and the grant price. Taxes are immediately withheld when you exercise the Nonqualified Stock Option. The cost basis of your shares is the value of the stock on the date you exercise the options.

For Example: You are given 100 Nonqualified Stock Option of XYZ Corp. on January 1st. You are able to exercise your options beginning July 1st. The Nonqualified Stock Options are granted at $10 per share. You decide to exercise your options on July 1st. The market value of XYZ stock is $20 per share on July 1st.

January 1st	100 shares	X	$10	=	$1,000 grant price
July 1st	100 shares	X	$20	=	$2,000 market price
					$1,000 ordinary income

Your new cost basis is $20 per share or a total of $2,000.

To maximize tax savings, the basic rules for stock options would be to exercise Nonqualified Stock Option before the stock increases in value and immediately recognize any income for regular income tax purposes. The lower the stock value, the lower the income benefit, and the lower the taxes. Then when the stock climbs, the profits (or gain) are taxed at capital gains tax rates, provided the holding period is met. As you can see, the initial outlay is relatively low but the risk is higher. If your new company does not succeed and you have exercised all of your shares, then you lose. Are you willing to take that gamble?

On the other hand, no income tax is withheld if we exercise Incentive Stock Options. Income is not recognized because you are purchasing the shares at a particular price (grant price). However, you must have the money to purchase the shares outright. You must hold the shares for at least one year in order to pay capital gains tax rates on the increase in the price of the shares.

If you exercise ISOs you must be aware of Alternative Minimum Tax (AMT). Alternative Minimum Tax is imposed this tax year on the amount of your income benefit—that is the difference between the fair market value on the day you exercised your options and the price you paid for them. The bigger the spread between the value and cost, the bigger the "income benefit" on which AMT is computed. If the AMT calculated on our annual tax return is higher than your regular income tax calculated, then you will have to pay the difference. Alternative Minimum Tax rates are 26 to 28 percent.

Before you opt to wait for Ed McMahon and your sweepstakes money rather than figure out if you would have any cash left from what you thought was your stock option windfall, note STOCK OPTIONS ARE STILL A GREAT DEAL. You just have to plan very carefully and consult a tax adviser or C.P.A. Timing is the key. If an employee receives Incentive Stock Options or Nonqualified Stock Options, it is critical to plan the timing for exercising the stock options.

A C.P.A. with a good understanding of your individual tax situation and the application of AMT can put together a strategy to minimize taxes and maximize income from stock options, and as a result, increase net worth. Your tax planning should always compliment your financial planning; more money saved in taxes is more money in your pocket.

The worst case of "not knowing" the tax rules on stock options we have encountered involved a young family who were just starting their careers with minimum income (below the 20% tax bracket). They received almost a million dollars in Incentive Stock Options. They exercised and purchased the options right away with the intent to hold the stock at least a year, hopefully watch the stock grow, and intended to sell the stock as needed. The only cash the family had to come up with was the cost of their stock options and then they were home free. Or so they thought.

The young couple had no idea about Alternative Minimum Tax and had been advised that there were no income tax implications on exercising their incentive stock options.

Alternative Minimum Tax on a million dollar income benefit for person in a low income tax bracket is more than $250,000. The family had no cash, after all they just spent their savings purchasing the stock options on December 29th. Come tax season, their accountant prepared their income tax return for the year and told them that they had to come up with $250,000 in taxes for a year when they jointly made less than $40,000.

In this and all stock option situations, timing is CRITICAL. If anything, the couple could have waited until January of the next year to purchase the stock. Now, their only option was to sell some of the stock to pay the taxes. They have "disqualified" the amount of ISO shares that they had to sell to pay their AMT. They do not get the favorable capital gains treatment because they held the stock less than one year and will pay ordinary income tax on the gain (provided the stock has increased in value) in the year they sold the stock.

Now, one significant attribute of the sneaky AMT is that you can carry the AMT payment forward. If you paid $250,000 in Alternative Minimum Tax last year, you can carry that forward as a credit every year until you use it up. I won't get into that calculation, but just remember, you do not lose the credit. It carries forward forever to offset regular income taxes provided you qualify for the credit each year.

As you can see, it is very important to consult with your financial planner or tax consultant. For more information regarding this topic, please contact The Henssler Financial Group at 770-429-9166 or comments@henssler.com.

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