John M. Hoffman & Associates CPAs

Frequently Asked Tax Questions

Incentive Stock Options (ISO)

ISOs are totally different than NQUALs with all the benefits of NQUALs and much more. NQUALs work in a fashion that as an employee if the company stock goes up and you wish to grab that profit, you do. With ISOs you have the additional opportunity to invest some of your own money in the company and then, by holding on, receive capital gain treatment on the profit from the stock. This is a little more complicated.

Let’s say that you started working at a small biotech company named CancerCure (CC). The company has good prospects but in order to attract top notch scientists to work their, CC offers ISOs to its employees. CC is not yet publicly traded but the board has a valuation of the company done every year to determine the value of the company stock. In fact, the most recent valuation shows that the company stock is worth $1. CC executives are pleased with your performance and on January 1, 2005 (two days after the $1 valuation) grant you ISOs on 100,000 shares of CC stock. The terms of the grant are that you vest in the options 20% per year and the price that you can buy the stock at is $2. This does not cost the company any current money but it does dilute the stock in the company which factors into future capital infusions or their ultimate goal of a public offering. Another footnote is that the options will expire five years after they vest.

What this all means is that over the next five years you will earn the right to buy stock in CC at a price of $2. The gradual component is the vesting. On each January 1 for the next five years 20,000 options are yours to exercise should you like. You can not transfer the options to anyone else and if the company gets sold, they become immediately vested.

So, lets walk through what happens and why there are complications:

On January 1, 2006 CC announces that the stock is now worth $3, even though there is no readily available market for the stock. 20,000 of your options have vested, meaning you can exercise them at any time. The company says that everything is going great guns and some of those biotech engineered drugs that are ready for testing look very positive.

You ask yourself, what should I do? You have three alternatives:

Do nothing but sit and wait (perhaps not a bad choice).
Exercise and hold some or all of the 20,000 options.
Exercise and try to sell some of all of the 20,000 shares you have options on.

Alternative 3 is not that viable as there is not much of a market for the stock so you might have a hard time finding a buyer. Your company just gave you another 50,000 options vesting over the next five years with a strike price of $4. For these to qualify as ISOs and not have immediate taxation upon grant, the strike price needs to be higher than the current market value which in both cases it was.

The company prospects look real good and you are convinced that there will be a market for your shares in a year or so and you are very interested in the ability to cash in on that future windfall and you want to do it so you only pay capital gains tax on the profit. With that in mind you go to alternative 2. You exercise all 20,000 options on January 1, 2006. Here is where you make an investment because you have to write a check to your company for $40,000 to exercise these options. You trust the valuation that tells you those shares are worth $60,000 and you are confident that the company is going no place but upwards.

What is the tax treatment of this transaction? The $20,000 of paper profit the difference between the $60,000 value of the stock you acquire and the $40,000 you pay for it is considered an alternative minimum tax (AMT) tax preference item. This means that you might pay AMT on this $20,000. You might not pay AMT on this if when you add it all up and you are still not subject to AMT. The bigger the item, the more likely the AMT is. There is no tax consequence for regular (and most state) income tax on this transaction of exercising the ISOs.

So now you have to think about this a bit. You wrote a check to your company for $40,000. Your accountant, Hoffman, is telling you that this is subject to AMT and at 28%, that costs you an additional $5,600. You still like where the company is going – after all - you are one of the brilliant scientist who invented that new drug for CancerCure. Besides, the option was exercised on January 1, 2006 and you won’t have to pay that AMT until April 15, 2007.

Now lets take a look at what can happen from here; now 4 alternatives:

For whatever reason you can not wait out the next 12 months and you sell your stock. By doing so, you have created a disqualifying disposition. This means that you can forget about the AMT and the whole profit on the deal is treated as ordinary income. In fact, you are supposed to tell your employer so they can report it as taxable wages. There are times when you might want to do this, such as the stock heading downwards and you wanting to bail out. Please note the distinct advantage of starting this one year transaction at the first day of a calendar year so that you have almost the entire 12 month holding period window falling within the same tax year – I know this is complex but if you dump the stock within 12 months but that dumping date falls into a subsequent year you still owe the AMT in the previous year – OUCH!

You wait out the 12 months and on January 2, 2007 the public offering for CC at $20 occurs. As to these 20,000 shares acquired one year and one day ago, you can sell the shares on January 2, 2007 and at that $20 price you collect $400,000. For regular tax purposes you have a long term capital gain of $360,000 taxed at 15%, or $54,000. For AMT, your capital gain is $340,000 because your basis for AMT purposes was increased from the $40,000 you wrote the check for by the $20,000 of tax preference that you had. All things being equal, your AMT is less than your regular tax and the AMT that you paid for the year when you exercised the options (bought the stock) is refunded (in theory).

Despite everything looking wonderful, and your patience, on January 2, 2007, the company gets bad news that the drug failed clinical tests and the company closes its doors. Not only are all those other stock options worthless, but the 20,000 shares that you paid $2 per share for worthless. For income tax purposes you have a $40,000 capital loss that you get to deduct $3,000 per year for the next 13 and 1/3 years. For AMT purposes you have a $60,000 capital loss that is deducted in the AMT calculation at a rate of $3,000 per year so that loss will last you 20 years. Despite having paid the AMT on the paper profit, you essentially will not get that back until years 14 through 20 when your AMT is less than your regular tax because you get that additional $3,000 of capital loss per year from years 14 through 16. In case you have not surmised – THIS is what you DO NOT want to let happen. Don’t forget that you still need to write that check for the $5,600 of AMT on April 15, 2007. This is particularly painful since the $40,000 you paid for the stock has gone down the drain, and now you have to pay tax on paper profits that evaporated (and from what source do you get the money to pay this tax)?

And this we think is the most likely event. On January 2, 2007 as an additional 20,000 of your original grant of options vest, and the first 10,000 of your 2nd grant vest, everything is smooth sailing. The company is continuing to make good progress and they just announced that the stock value has gone to $6 and you have been granted 30,000 additional ISOs with a strike price of $10, vesting 20% per year going forward. There is no current market for the shares but you are confident that an IPO is just around the corner. Accordingly, you decide to exercise another 20,000 of the original options, writing the company a check for $40,000 and including $80,000 of AMT preference. This could cost $28,000 in AMT the following April. I think you can see that the money is getting real serious here.

Still within alternative 4, let’s take a look at how this breaks down financially.

You own 40,000 shares of stock that are worth $240,000. Your cost for those shares is $80,000 and you are halfway home as to the $160,000 gain being taxed as long term.

You have reported AMT income on those shares of $100,000 and paid AMT of $28,000 that you hope to get back some day.

On the 1st grant of options you control 60,000 more shares of stock, each currently worth $6, with a strike price of $2. This is one paper worth something like $240,000 right now ($4 profit per share times 60,000). None of these remaining options have vested yet.

On the 2nd grant of options that you have not exercised you control 50,000 more shares, worth $6 each with a strike price of $4. This is an additional paper profit of $100,000.

The 3rd grant of options are not worth anything yet as their strike price of $10 is below the current value of $6 – we call those “under water”.

On paper you have profits of $500,000. Making it even more exciting is that every $1 increase in the price of the stock increases your profits by $150,000. When the price gets over $10, and that last grant has worth, that incremental $1 per share increase now adds $180,000 to your net worth.

You can see how exciting and how complicated this can be. You should also see that you probably want to exercise the options gradually (the vesting schedule sort of forces this hand), and then there is a chance to take some profits off the table, you might want to. Imagine how many millionaires that cashed out their Google options are sitting their today feeling remiss about missing out on being that much richer if they had held on. The pain that they feel can not be nearly as great as all those folks who watched their paper profit in companies such as Lucent, CMGI, Worldcom, and others disappear and become worthless. Lacking a crystal ball, you need to balance cashing in some profits and not let the greed of wanting more allow it all to evaporate.

Let’s go back to that AMT that you paid on the exercise of the options. For that alternate calculation (AMT) you had to include in income the paper profit on exercising those ISOs. If you hold the shares for a year and then sell to get capital gains treatment, aren’t you going to end up paying double tax? No is the theory. This happens because when the AMT is due to a timing difference between regular and AMT (this is timing as to recognizing the profit when you exercise in one case and when you sell in the other), the AMT is refunded to you when your regular tax exceeds your AMT. When you sell those shares that you had a big ISO exercise AMT preference item on, your basis for determining gain or loss for AMT purposes includes that amount of preference income. Because you will use this higher basis, your gain for AMT is smaller and your AMT is likely smaller and your regular tax is reduced down to that much lower AMT through a credit of minimum tax credit carryforward. If this is not complicated enough to confuse a nation, we don’t know what is.

So you might make the statement that the AMT that you pay on the ISOs is simply a temporary thing as you will get that refunded some day. Don’t be so certain. Let’s say that a middle class taxpayer with $200,000 of income is in the AMT all the time anyway. That taxpayer has a one shot deal of ISOs that results in a large AMT. Since the taxpayer is in the AMT most every year anyway, there is no way to get that credit to kick in and be refunded. When you sell your shares, perhaps that will trigger a smaller gain for AMT and a smaller tax for AMT and the refund of the old AMT through the minimum tax credit. The problem is that if the stock plunges in value and you end up with large capital losses for both AMT and regular tax purposes, you only get to deduct $3,000 for either calculation, and once again your tax is driven by the AMT and you get no refund through that credit.

We tell people in these situations that they may take that AMT credit carryover to their grave. This is a serious problem and has actually put taxpayers into bankruptcy. Imagine if the tax is triggered and determined on a given day from an ISO exercise but before the stock is sold to pay the tax, the stock plunges. The taxpayer owes the AMT, has no money to pay it from because the stock is worthless, and as to the stock being worthless, for both AMT and regular tax purposes can claim a $3,000 capital loss for the rest of their life. This is clearly not the result that congress had in mind. Congress had in mind a stock that kept increasing in value and, a stock that had a ready market to sell into.

Recognizing this, there is a little known provision put into the tax laws in 2006, effective for 2007. It allows taxpayers within a certain range of income, who had AMT credit carryforward from certain years to claim a credit for that old AMT. This is a five year provision and each year the credit allowed is for 20% of the amount carried forward from the previous year. This math does not quite get all the credit back as taxpayer’s will be allowed 20% of a shrinking pile each year, but like they say, it sure beats a stick in the eye.

Stock Market Call Contracts

These “options” as they are known, are contracts that allow people to exercise some control over certain shares of stock over a certain period of time. These contracts allow people to speculate on a stock for much less money and much less risk than actually owning the stock.

Take a stock like Exxon Mobil (XOM) for example. On 11/26/07, the stock was trading at $85.61 per share. For me to buy 100 shares, I would need $8,561. XOM has been a great stock over time and it has always paid a nice dividend.

Let’s say that I think that the stock is really going to the moon over the next six months, and I want to take a chance and profit on the XOM prospects. Unfortunately I don’t have lots of money and in fact I do not have $8,561 plus commission to buy 100 shares of XOM.

If I am a real risk taker, I could buy an option that lets me profit, if XOM really does take off over the next six months. I look on line and find that I can buy a contact for 100 shares of XOM allowing me to buy 100 shares of XOM at a price of $90 each, anytime between now and the third Friday in April of 2008 for $5.60 per underlying share, or $560 for the contract.

If I purchase this contract, known as an April 2008 XOM 90 call, I have the right anytime between today and April 19, 2008, to have those 100 shares for $90 each, no matter how high they might be. If I don’t exercise that contact before April 19, 2008, the contract expires and becomes worthless. You may wonder why I am buying a contract for the right to purchase the stock at $90 when I can not afford it at $85.61?

Good question. My thought is that someone else will buy my contract from me, and that is how I will make my profit. Why would my contract go up in value? If XOM goes to $110 per share, the profit per share is $20 or $2,000 for the contract (this would be the amount that the contract is “in the money”).

If that happened tomorrow, someone would pay me more than $20 per share or $2,000 per contract because not only did they have the right to cash that in the next day for that “in the money” amount, they got to sit and watch and see if it made more during what is left of the time on the contract. There is a premium associated with being able to control roughly $10,000 worth of stock over the next 5 months.

So, the stock went up $25 overnight and my call contract went from $5.60 to $25.60 overnight. Please note that the stock and the call contract generally go up and down in the same direction, not always at the same dollar amount. I sell me contract for $2,560 and profit $2,000.

How is this transaction taxed?

This transaction is taxed as a short term capital gain (see capital gains and losses).

What happens if, instead, I sit and watch and on April 19, 2008 the stock is still at $85.60 and I let the option expire? In that case, I have a short term capital loss in tax year 2008, with a sale for zero on April 18, 2008 and a buy for $560 on November 26, 2007.

What happens if instead, I do have the money and on February 8, 2008, I exercise the option, paying $90 per share (I exercised early as the stock was going ex dividend and I wanted to be paid that nice dividend), and I now sit and hold my 100 shares of XOM. What happens is that I effectively paid $95.60 per share for my XOM stock. Please note that for capital gain holding period definition, my holding period for these XOM shares began the day after the option was exercised.

So, as you can see, if that stock is really going to shoot up, I can make a lot of money by purchasing the call option contracts. Don’t get too excited, most call option contracts end up expiring worthless.

The other thing to understand is that I purchased that call contract from another investor, likely an investor who actually owned some XOM stock. You may wonder why that person would want to sell me that contract and how that person went about it. That person, perhaps wanted to be on the other side of this “bet”, thinking that the stock was not going to go up dramatically, and willing to sell for that premium the upside of the stock while holding the downside risk of the stock. This person offered to sell this contract on the same market that I offered to buy it.

How would this transaction be treated for the person selling the contract, say I was the person selling?

In the first fact pattern the call contract was sold by me (stockholder) to investor 1 who sold to investor 2. For me (stockholder), there is no consequence (in fact I don’t even know it happened) of this trade of the contract.

In the second example, the option expired and I the selling stockholder got to keep the $560. The transaction looks odd because I sold it in November of 2007 but didn’t close the contract until April of 2008. This is a short term capital gain for tax year 2008. It has a cost of zero on April 19, 2008 and a sale price of $560 on November 26, 2007. Because this transaction can often lapse over tax years, the sale of the call option contracts is not reported to the IRS but it is still a taxable event when the contract is closed.

If instead the stock goes to $110 and while I sit their crying, my shares are called away from my account in February for $90. This is treated just like any other sale of a stock and may be a gain and may be a loss depending on when I purchased the stock.