Get Your Exercise Tax Planning With Nonqualified Stock Options

Estate Planner Jul-Aug 2000
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Nonqualified stock options, whether in a “dot com” company or in an “old economy” company, can be valuable assets. But to make sure you don’t lose too much of that value to Uncle Sam, you need to understand the tax ramifications and plan accordingly.

You normally receive nonqualified stock options for the performance or future performance of services. Section 83 of the Internal Revenue Code governs the income tax consequence of property you receive in connection with services. But for these purposes, the receipt of a stock option is not considered receipt of property if the option doesn’t have a readily ascertainable fair market value at its grant. (If it does, a taxable event may result from the grant.)

But when you exercise the stock option and receive the stock, a transfer of property occurs and Section 83 may apply. Generally, when the option is exercised, the difference between the share value at the date of exercise and the exercise price will be taxed to the option holder as compensation income (unless there are restrictions on the property received).

Once the option is exercised, the compensation portion of the transaction is complete and the employee then holds the property as investment property (assuming it is a capital asset in his or her hands.) The option holder’s basis in the option will be the cost of the option, consisting of the sum of the exercise price plus the amount of compensation income recognized by the employee under Section 83.

Let’s take a closer look at how Section 83 affects nonqualified stock options.

Determining Ascertainable Fair Market Value

Four conditions must be met for your option (which is not actively traded on an established market) to have a readily ascertainable fair market value:

1. The option is transferable by you as the option holder.

2. The option is exercisable immediately in full by you.

3. Neither the option nor the underlying property is subject to any restrictions that have a significant effect on the option value.

4. The fair market value of the option privilege is readily ascertainable.

Even if the option’s value becomes readily ascertainable between the date of the grant and the exercise date, you still do not recognize income until you exercise the option. Under Section 83, the difference between the share value at the date of exercise and the exercise price generally will be taxed to you as compensation income (unless there are restrictions on the property received).

This closes out the compensation aspect of the transaction and you then hold the stock as investment property (assuming it is a capital asset in your hands). Your basis will be the cost of the option (the sum of the exercise price plus the amount of compensation income you recognized).

Determining Risk of Forfeiture

As part of your tax planning, you may defer income recognition on the exercise of stock options until the actual sale if the stock received is subject to substantial risk of forfeiture and transferability restrictions. Two questions are helpful in determining whether your stock meets these conditions:

1. Are the required services “substantial?”

2. Are the forfeiture conditions likely to be enforced against you, as the employee?
Services may be considered substantial if you have to perform them to keep the shares of stock. If you have the right to decline to perform such services without forfeiting the stock, then they may be considered insubstantial.

What if your employer transfers stock in connection with your performance of services as an employee? Under the terms of the transfer, you are subject to a binding commitment to resell the stock to the corporation if you terminate your employment for any reason before the expiration of a two-year period from the date of the transfer.

In this example, your rights in the stock would be subject to a substantial risk of forfeiture during the two-year period. The compensation element of the stock received under the options remains open until the restrictions on transferability lapse and the forfeiture provisions no longer apply.

Making a Section 83(b) Election

You can elect under Section 83(b) to close the compensation element of the transaction at the time you receive the shares of stock from your employer. When you make the election, you will recognize income on the difference between the value of the shares and the option price. If there is no difference, then you will not recognize compensation income. Any appreciation — from the time of the election until the time of the later sale — is potential capital gain. You must make the election within 30 days after the property transfer. If there is a chance the value of the property will appreciate, making a Section 83(b) election is generally advantageous. After you make the election, any increase in the value of the shares received under a nonqualified stock option will be taxed at the lower capital gains rates, rather than as ordinary income. If no election is made, when the restriction lapses, the full value of the property (less any amount paid for the property) will be taxed as ordinary income.

Receiving the Most From Your Nonqualified Stock Options

If you receive nonqualified stock options from your employer, be aware of the tax ramifications of Section 83 when you exercise the option. With a clear understanding of how Section 83 affects nonqualified stock options, you can realize a greater return.