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Lower tax hit on nonqualified stock options

by on
in Small Business Tax,Small Business Tax Deduction Strategies

As the owner of a small business or one of your company’s top employees, you may be granted stock options as part of your compensation package. What type of options are you receiving? It can make a big tax difference.

Reason: With incentive stock options (ISOs), also called “qualified” stock options, you may benefit from tax deferral and favorable capital gain treatment on the sale of the stock if certain requirements are met. Conversely, in-the-money nonqualified options are taxable at the time of exercise.

There’s no getting around this rule. But you can still take advantage of a special tax opportunity for nonqualified options that isn’t available to ISO holders.

Strategy: Transfer nonqualified stock options to low-tax bracket family members. This timely move can save both income tax and estate tax in the future. Unlike an ISO, you’re allowed to hand over ownership rights to a nonqualified option from the get-go, assuming your company’s option plan allows this.

Here’s the whole story: Generally, a nonqualified option is taxable when it is granted if it has a “readily ascertainable fair market value” at the time (e.g., the option is publicly traded on a major exchange, which is rarely the case). If the option doesn’t have a readily ascertainable fair market value (the usual situation), you must pay tax when the option is exercised to the extent it is in the money.

In other words, the taxable amount is the spread between the stock’s exercise price and its fair market value (FMV) at the time of exercise.

Although you can’t avoid the initial tax hit, you can cut the future tax bill by giving away options before you exercise them.

Example: Avoid a future shock

Connie D’Antino had been granted nonqualified options to buy 1,000 shares of company stock at $10 a share. She decides to exercise the options when the stock is worth $15 a share. This means that Connie must pay tax on the $5,000 spread.

If Connie sells the options before 2013, any long-term gain will be taxed as a capital gain at the maximum 15% rate (0% for certain low-taxed individuals). The tax rate is scheduled to increase to 20% (10% for the lower-taxed individuals) for sales after 2012. If she keeps the stock or the proceeds from the sale, the assets will be included in her taxable estate.

Better idea: Connie can arrange to have the nonqualified options transferred immediately to a low-taxed family member like her child. (You can’t do this with ISOs.) The IRS has previously said that such a transfer qualifies for the annual gift-tax exclusion. (IRS LR 9514017) Currently, the gift-tax exclusion can shelter transfers up to $13,000 per recipient per year. In this case, the gift is only $10,000, so there are no gift-tax consequences.

Because she is giving up total control over the nonqualified stock options, the options won’t be included in Connie’s taxable estate. So, there’s no estate tax on the appreciation in value.

Icing on the cake: If Connie’s child subsequently sells the stock, the gain is likely to be taxed at the maximum 0% capital gains rate (scheduled to be 10% after 2012).

Caution: Suppose an employee gives away the options before exercising them, but after they’ve appreciated. In that case, the value of the gift is the appreciated FMV of the options at the time of the transfer. For instance, if the stock is worth $14,000 at the time of the transfer, the employee owes gift tax on $2,000 (but the tax may be eliminated by the $5 million lifetime gift-tax exemption).

Tip: When a nonqualified option is exercised, your company can deduct the difference between the FMV of the stock at the time and the exercise price. That’s one reason why some companies favor nonqualified options over ISOs.

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