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

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

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

Now what — I feel rich, do I rush to buy my stock as soon as I am vested at this bargain price and sell it or what?

Ok, slow down, hold on. Before we jump right in and exercise our rights to buy the company stock let's see how much cash we really 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 ISO's) and Non Qualified Stock Options. These two types are treated very differently on your annual tax returns and greatly differ in the amount of tax that could be owed because you have exercised your rights to buy the stock options.

When we exercise (which is when we have the right to purchase) non-qualified options, we will recognize ordinary income equal to the difference between the fair market value of the company stock on the date we exercise and the price we actually paid for the stock option. This income difference immediately has taxes withheld at the point we exercise the stock option. Our basis or cost in the options is now the market value on the date we exercised.

To maximize tax savings, the basic rules for stock options would be to exercise nonqualified stock options 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 our new company does not succeed and we have exercised all of our shares, then we lose. Are we willing to take that gamble?

On the other hand, no income tax is withheld if we exercise Incentive Stock Options, so let's be smart and just purchase the ISO's we have just become vested in and decide to hold the stock options at least a year to receive long term capital gain treatment and only pay a 20% rate on the gains. Good deal, huh?

Well, now what we have done is put us in a particularly hazardous Alternative Minimum Tax situation. The commonly called Alt Min Tax is imposed in this tax year on the amount of our income benefit (which is the difference between the fair market value on the day we have exercised our options and the price we paid for them). The bigger the spread between the value and cost, the bigger the "income benefit" on which Alternative Minimum Tax is computed. If the Alternative minimum taxes calculated on our annual tax return are higher than our regular income tax calculated, then we will have to pay the difference. Alt Min Tax rates are 26 to 28 percent.

OK, now listen to me, before we decide that we'd rather wait for Ed McMahan and our sweepstake money rather than figure out if we would have any cash left from what we thought was our stock option windfall, STOCK OPTIONS ARE STILL A GREAT DEAL. You just have to plan very carefully. AND consult a tax advisor or C.P.A. Timing is the key. If an employee receives Incentive Stock Options or Non Qualified Options, it is critical to plan, plan, and plan the timing of the exercising of the stock options.

A C.P.A. with a good understanding of the individual's tax situation and the application of Alternative Minimum Tax 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 I have had involves a young person with a young family just starting their careers with minimum income (below the 20% tax bracket) and had received almost a million dollars in incentive stock options. He exercised and purchased the options right away with the intent to hold the stock at least a year, hopefully watch the stock grow, and sell the stock as needed. The only thing cash that 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 over $250,000. Did you get that? Over $250,000!! So we have no cash, after all we just spent our savings purchasing the stock options on December 29th. Now our accountant has prepared our income tax return for that year and has told us that we have to come up with $250,000 in taxes for a year when we jointly made less than $40,000.

In this and all stock option situations, timing is CRITICAL. If anything, we could have waited until January of the next year to purchase the stock. Now, our only option is to sell some of the stock to pay the taxes. I think that old saying of "to have and to hold" just went out the window. We have now "disqualified" the amount of ISO shares that we had to sell to pay our Alt Min Tax. We do not get the favorable capital gain treatment because we 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 we have sold the stock.

Now, one significant attribute of the sneaky Alt min tax is that you can carry the alt min tax payment forward. If we paid $250,000 in alt min tax last year, we can carry that forward as a credit every year until we use it up. I won't get into that calculation, but just remember, you don't lose the credit, it can carry forward forever to offset regular income taxes (provided you qualify for the credit each year).

Did I mention how important it is to consult with your C.P.A., who knows how critical timing is for tax planning and projections?

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