Question: I hold incentive stock options which I received from my employer. Since the stock is trading above the option exercise price, should I exercise the options and acquire shares of employer stock or do a cashless exercise?
Answer: The specific answer to your question requires consideration of what your cash needs are, your time horizon, and, most importantly, how the stock will perform in the future. Clearly you cannot make financial decisions based on future stock performance; the best you can do is venture a guess as to whether the stock will appreciate or depreciate in value. You can, however, focus on the other relevant factors which you have not shared. Strictly from a tax perspective, if the stock continues to hold its value and perhaps appreciate further in value, the best overall tax result is to exercise the option, acquire the shares and either hold the shares long-term or sell the shares and report a long-term capital gain from the sale.
Incentive stock options (“ISOs”) are options an employee holds to acquire stock of the employer corporation at the price set forth in the option grant. The option can be exercised for any period of time specified in the grant but, by law, cannot exceed ten years. Employees typically wait until the stock appreciates beyond the exercise price before exercising the option. An employee can exercise the option to acquire the stock and either sell the stock at the appreciated price or hold the stock for future growth and perhaps later sale. Some plans such as yours permit cashless exercises whereby an employee need not actually exercise the option and purchase the stock but can instead receive a payment for the stock equal to the difference between the current stock price and the option exercise price, a cashless exercise.
With stock options there are, generally speaking, three relevant time periods for determining the tax consequences of the transaction. The grant of an option triggers tax consequences only in the rare circumstance where the employer stock option is itself publicly traded. In many cases, tax consequences arise when the employer exercises the option at which time the employee reports ordinary income based on the difference between the stock’s fair market value and the exercise price. As you are fortunate to hold ISOs, the tax consequences are deferred until the stock you acquire with the option is actually sold provided you satisfy the various statutory requirements applicable to ISOs. At the time of a cashless exercise, ordinary income must be reported based on the difference between the cash received from the exercise and the exercise price. This is the same tax treatment which applies to an employee who exercises a non-qualified stock option or an option which is not an ISO.
If you are concerned about the stock price dropping, the cashless exercise may be the safest course of action as you will receive immediate payment for the appreciation without any risk. The cashless exercise is of course the costliest option from a tax perspective as ordinary income must be reported at the time of exercise and that same amount of income is subject to payroll taxes. If you instead exercise the options, acquire the stock and hold the shares for a period of more than one year, then any gain from the stock sale will be taxed to you at a more favorable long-term capital gain rate. Clearly this is a better option from a tax perspective but you are then risking the potential loss in value if the stock price drops and you forfeit the economic benefit you have already realized.
You are obviously in a beneficial position having received ISOs which are the most desirable form of stock option an employee can receive from an employer. You might consider the fact that under the terms of your employer’s stock option plan, this is likely not an all-or-nothing proposition. That is, you can exercise some options and hold the acquired stock for a period of more than one year making any gain from the sale eligible for long-term capital treatment if and when sold. You can simultaneously do a cashless exercise for the other options that you hold. Splitting the difference in the stock option strategies may serve to balance your risk while also allowing for the benefits of long-term appreciation and more favorable tax treatment upon the sale of the stock you acquire with the options.
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