Exercising Your Incentive Stock Options – Part III August 3, 2001February 20, 2017 If you don’t have stock options at work, do yourself a HUGE favor and skip this column. Seriously. Sreenivas I. Rao: ‘Lot of people have lost their houses paying the Alternative Minimum Tax (AMT) on ‘phantom gains’ here in the Silicon Valley. Check reformAMT.org. Some of the strategies discussed can backfire, with disastrous consequences.’ ☞ For a specific human face on one of these horror stories, click here. Marcus Wu: ‘Individuals selling ISOs should also beware of the 30-day wash sale rule under the Internal Revenue Code. Here’s an example of how those rules could zap you: Xavier exercises an incentive stock option in March when the stock is trading at $100/share. By December, it’s down 99% to $1/share. Xavier doesn’t want to pay AMT on stock valued at $100/share. He knows that if he sells the stock before the year is up, then the option is not treated as an ISO and there is no AMT due. WHEW! Xavier is relieved and sells. But he believes in the company and wants to ride the stock back up. So he buys some stock and makes the horrible mistake of doing so within 30 days of selling his ISO shares. Oh, no! Xavier owes the AMT — see 422(c)(2)(B) of the Code — because his December sale is negated (for tax purposes) as a ‘wash sale.’ ☞ Oh, no, indeed. The estimable Less Antman: ‘I have one quibble with a comment from one of your readers: As for paper millionaires stuck with AMT, they could always sell off some of their junk to generate some AMT loss (and get some cash to pay AMT on the rest of the gain). The AMT basis is the fair market price at exercise (the value used to compute the AMT gain). ‘Perhaps the reader meant selling the shares within the same calendar year (as another reader recommended when proposing that exercising should be done in January to allow time to decide), but this won’t help the Silicon Valley paupers stuck with the tax bills of millionaires: ‘(1) The net capital loss deduction for AMT purposes is limited to $3,000 per year, just as it is for regular purposes. If you exercised ISOs when there was a $1,000,000 spread, then sold the next year after a collapse caused it to totally disappear (or worse), you’d eventually get to claim the loss of $1,000,000 for AMT purposes, but might have to spread it out over the next 334 years. So unless there are lots of other capital gains lying around waiting to be had, this isn’t going to work. ‘(2) Any credit in a later year for AMT paid in an earlier year can only reduce the regular tax bill. After the high technology party ended, most of these people were left with only their regular salary (assuming their company wasn’t actually dot-gone), and the regular tax bill on the 2001 salary is going to be a pittance compared to the AMT paid in 2000. Even if they had later capital gains, the AMT rate is 28% on ISO exercises, so it is going to take a lot more long-term capital gains at 20% to get the tax benefit from all the ISO losses. Most of these people will NEVER recover the AMT paid, or anything remotely close. ‘The reader was correct in saying the ideal approach is to figure out how many ISOs can be exercised without triggering the AMT in the first place. And that it is a complicated calculation, which really means people with profitable options ought to pay for the services of a tax professional. But most of the Silicon Valley crowd thought they could do their own taxes with TurboTax, so they only found out when they sat down in April 2001 what they had done to themselves by exercising in early 2000 and holding for a year and a day. And then it was too late. ‘Which gets back to the point that the safest thing to do with any employee stock option, non-qualified or incentive, is hold until you have a good gain and then sell the shares immediately after exercise. Forget the taxes: it is almost inconceivable that the beneficiary of a giant stock option windfall isn’t, after exercise, going to have the majority of his net worth in a single stock, in the company which also pays his salary, and which is likely to be an overpriced stock given the price rise needed to create the windfall. The need for prudent diversification overrides the potential benefit of saving the spread between the ordinary and long-term capital gains rates by holding for over a year. The stock market as a whole can’t go to zero, but plenty of individual stocks drop below the exercise price of employee options, and some of them stay there permanently. ‘P.S. Kaye Thomas’ brilliant book, Consider Your Options, discusses this topic in excruciating detail.’
Suited to a Tea; Trent Lott, Man of the People August 2, 2001February 20, 2017 What a great week. First, I got my roughly quadrennial clothes shopping out of the way: five suits and a tuxedo (plus five pairs of dress socks and two belts) – including alterations, sales tax and delivery – $1,509. Where? Men’s Suits, of course, 118 East 59th Street (second floor), of which I’ve written before. Entire elapsed time of my visit: 31 minutes. This is my kind of shopping experience. (I have no stake whatever in Men’s Suits. And, yes, I know there are even cheaper ways to buy clothes, but I don’t mind paying through the nose for cachet.) Then I found Honest Tea at Fairway, on 74th and Broadway. (I do have a stake in Honest Tea.) I bought two cases each of First Nation and Moroccan Mint, one each of Jakarta Ginger and Community Green. Some are caffeine-free, some 1/4 or 1/3 or 1/2 as caffeine-laden as coffee. I was a little troubled that Fairway didn’t seem to know it carried Honest Tea – you’re not lying to me about this, are you, I asked in mock menace, making an Honest Tea pun that I’m fairly certain fell shy of its mark – but then, sure enough, they found 20 cases under a counter of fruit. So please be persistent. Demand your Honest Tea. But enough about me. Rob Sartain: ‘Yes, ‘Malcolm in the Middle’ is the funniest, most clever show on television. But it’s on Fox Sundays at 8:30, not 9:00.’ ☞ Oops. Well, I was not entirely wrong: this Sunday they are showing three episodes back to back, starting at 8:30 Eastern time on Fox, with another episode and 9 and a third at 9:30. Cool. (Oops, also, to those of you who gave ‘Prime Time Glick’ a try last night – it was not his best.) Jim Hamilton forwards this from the BNA Tax Management website: Lott to Offer Two-Year Capital Gains Cut, Holding Period Elimination Senate Minority Leader Lott says he plans to offer an amendment to temporarily lower — as an economic stimulus — capital gains tax rates from 20 percent to 15 percent when the Senate considers raising the minimum wage this fall. “I’m suggesting that would be something that we would probably want to do,” Lott says. A Senate GOP leadership aide tells BNA Lott’s proposal also would involve elimination during the two years of the rate cut of the asset holding period before a taxpayer would be eligible for the capital gains tax rate. ☞ Senator Lott represents the 49th or 50th poorest state in the union, where a minimum-wage hike, which he has traditionally opposed, could help a lot of struggling people. His plan, apparently: In return for a 25% hike in the minimum wage, from $5.15 an hour ($10,300 or so for a full work year) to $6.50 or $6.75, he would cut the already favorable long-term capital gains rate by 25%, from $200,000 on each $1 million gain to $150,000 … and cut it, for high-income folks, by about 60% on short-term gains, from about $400,000 on each $1 million to that same $150,000. ‘Well, my friends have got to get some benefit out of this minimum wage thing,’ he must be thinking, feeling their pain. (The part about removing the distinction between long and short-term gains I think is not so dumb. Even without it, there’s a big incentive to hold for the long-term – your investment grows untaxed until you sell. Why encourage people to hold for a year and a day if they think their capital is better allocated someplace else? They might even be right. Perhaps to keep it revenue neutral the rate should be, say, 22.5% regardless of the holding period.) VERMONT Finally, if you come down on the side that opposes gay civil unions, read this and see if you remain unmoved. Tomorrow: One Last Crack at Incentive Stock Options (Reason Enough to Take Friday Off)
Exercising Your Incentive Stock Options – Part II August 1, 2001February 20, 2017 But first, for those with no options but a TV . . . it’s Wednesday, and not too late for those of you who missed it earlier in the year to catch The West Wing re-run at 9pm on NBC . . . and then, after a suitable break to savor it and switch moods, Prime Time Glick on the Comedy Channel at 10:30. The thing to know about Jimminy Glick is that he is really Martin Short with about 100 pounds of make-up. If you have never heard of Martin Short, this may not mean much to you. But if you have, I think you will soon come to wish his talk show were nightly instead of weekly. And is it too early to start looking forward to Sunday? Malcolm in the Middle at 8:30pm on Fox is the best thing on commercial television, barring only The West Wing. And on HBO – which we finally broke down and started paying for 15 years after everyone else – there’s Sex in the City at 9pm followed by Six Feet Under. I have set the latter two in purple to indicate that they are on the racy side, and not for everyone. But they are terrific. [Note: As with any series you join in midstream, you really need to watch two episodes to give them a fair chance. I came this close to abandoning The Simpsons after a single episode (‘What are they saying? I can’t understand them!’), and shudder now to think what I would have been missing had I not come back for more. I still can’t understand much of what they’re saying on South Park, but for this I blame Canada.] Now, for those of you with no TV but incentive stock options . . . Beth Moursund: ‘Not all options work the same as your description in Tuesday’s column. I used to work at Microsoft, and had a very nice pile of options granted to me. Those particular options (and I don’t remember the particular IRS type-code) counted the difference between option price and current price as ‘ordinary income’ on the day exercised. Not short term gains — ordinary income, with Social Security and Medicare and all the rest of the taxes due without even getting AMT involved, whether you kept the stock or sold it. Anyone thinking about exercising options should check on the details and make sure they know which rules apply to the ones they have.’ ☞ Indeed. (See Michael Young, below.) Martin Fleisher: ‘What I advise clients to do about exercising ISOs is to do so as early in the year as possible, e.g., January 2. If the stock stays above the exercise price by the end of December, hold on to it and sell the following week when the 1-year holding period has passed. If the stock has declined below the exercise price, sell by 12/31 and no AMT.’ Andy Long: ‘I tell my students that there are only two times an option should ever be exercised: 1) When they are about to expire (assuming that they are in the money) or 2) Immediately before you plan to sell the stock. This has nothing to do with tax consequences, it is simply a matter of maximizing the underlying leverage of the option. There is no reason to give up the advantages of leverage until you are forced to.’ Michael Young: ‘Your write-up today on stock options really applies only to ISOs (*qualified* incentive stock options). Because of some of the qualifications and limitations, as well as corporate tax ramifications, many companies give out NQSOs (non-qualified stock options), instead of, or in addition to, ISOs. For example, IBM offers ISOs only to ‘executive level employees,’ but NQSOs to other people they want to retain. Even some startup companies have gone to issuing some NQSOs. ‘The tax treatment is quite different. When an NQSO is exercised, the difference between fair market value and strike price is immediately taxable as regular income. (On the bright side, there’s no AMT to worry about.) Not nearly as good as ISOs, but still better than no options at all. ‘As for paper millionaires stuck with AMT, they could always sell off some of their junk to generate some AMT loss (and get some cash to pay AMT on the rest of the gain). The AMT basis is the fair market price at exercise (the value used to compute the AMT gain). ‘The approach I recommend for ISOs that look like they’ll stay in the money is to exercise and hold as much as you can afford without running into AMT. Most people have a fair spread between their regular tax and AMT to work with. For me, the hassle to estimate the spread is worth it to get the long-term gains rate, but I recognize that many would balk at the complication. ‘But, one reason not to exercise until you’re ready to sell (which you may have implied but didn’t come right out and say): you don’t tie your money up. If you’re a startup founder, and your exercise price is a pittance, this isn’t a factor, but for most people, it can be.’