Employers can reward top employees, including company owners, by awarding them incentive stock options (ISOs). Generally, there’s no tax due when the company issues the ISOs or when the individual exercises the options. The IRS taxes the employee only when he or she finally sells the stock.
Strategy: Keep the options for the required holding period. As a result, the IRS taxes any gain at long-term capital gain rates.
Currently, the maximum federal tax rate on long-term capital gain is 15%. (The rate is scheduled to increase to 20% after 2012.)
Here are the key requirements:
- The option must be granted under a plan that specifies the number of shares of stock to be issued and the employees eligible to receive them.
- The plan must be approved by the stockholders of the employer corporation within 12 months of its adoption.
- The option must be granted within 10 years of the date the plan is adopted or the date of stockholder approval, whichever comes first.
- The option must be exercisable only within 10 years of the date it is granted.
- The option price must equal or exceed the fair market value of the stock when the option is granted.
- If the employee receiving the option owns more than 10% of the voting power of the employer’s stock (not counting the option stock), the option price must equal or exceed 110% of the fair market value of the stock when the option is granted.
- The option cannot by its terms be transferable other than at death and cannot be exercisable during the employee’s life by anyone other than the employee.
Assuming these requirements are met, you can benefit from the favorable capital gains rate if you:
- Sell the option stock more than two years after the option is received.
- Sell the option stock more than 12 months after the options are exercised.
Example: On Nov. 1, 2010, Day-Glo Paint Corp. granted its CEO, Stan Linebeck, an option to buy 100 shares of its stock at $10 a share. Stan exercises the option on Oct. 1, 2011, when the market price of Day-Glo is $15 a share. Then he sells the shares on Nov. 15, 2012, at $20 a share. Thus, his taxable gain is only $1,000 (100 shares x $20/share sales price minus $10/share exercise price).
Even better, the entire $1,000 gain is low-taxed capital gain. So Stan pays just $150 in tax (15% of $1,000) on his $1,000 gain.
What happens if the stock is sold at a price lower than the exercise price? The seller’s basis is the exercise price, so the sale results in a taxable loss. If the sale price is higher than the exercise price but lower than the market value on the exercise date, the seller still has a taxable gain.
On the downside: ISOs have some potential drawbacks, For example, the company generally isn’t entitled to a deduction for the options. Also, exercising an in-the-money ISO can trigger alternative minimum tax (AMT) complications (see box below). And, to qualify as an ISO, the exercise price must equal the stock’s fair market value at the time the option is granted.
Tip: In contrast, nonqualified options are tax-deductible for employers.
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