Individual Tax Planning for Stock Options

Scott Testa:Hi. Thank you. The first question is why stock-based compensation? It's a way for companies to attract and retain key employees. The good thing about stock options, it gives the employee an equity interest in the company without any cash outlay and it provides incentive for employees to improve performance in the company in order to maximize company's stock value. It works in both of their interests, and due to the non-cash aspects of options, employers are able to use them as a way to provide key employees with compensation packages without using any cash outflow. Real quick on stock options 101. It's a right for the employee to buy the firm's stock at a specific exercise price at or before a certain date.

The key here is that the employee controls the timing of the income as they can choose when they want to exercise the stock options. If the exercise price is less than the fair market value, I generally call this the spread. It's profitable to the employee who can create immediate profit from the stock purchase. So employees, a lot of our clients have questions about when to exercise, when to sell, and what are the tax implications of these stock options? Stock options 101. We'll talk about different rules, about different types of stock options. They divide the compensatory stock options in two categories, incentive or statutory stock options. This is provided by the Internal Revenue Code and the strict rules.

One of them is that they're not transferable by the individual to whom the option is granted and they're only exercisable by that individual. For non-statutory or non-qualified stock options, as the name suggests, they're not delineated in the internal revenue codes. There's a lot more flexibility there. There's a way to transfer them to heirs or kids or trusts. They can't be exercisable by another person, but you can never transfer the compensation element. Basically these are options that don't meet the requirements of statutory stock options and once the classification is determined, it doesn't change. All right, we'll get into first the requirements of the stock option. I don't want to get into too many details that are in the Internal Revenue Code, but more so the issues and requirements that are applicable to the employees.

It's an option. There's several key requirements. One, it must be an employee. So an independent contract or a board member cannot receive incentive stock options. There's a 10-year exercise period. The exercise price has to equal the fair market value on the date of the grant. It must be exercised during your employment or within three months of employment termination. If the employee is disabled however, the exception is extended from three months to 12 months. And then importantly for it to be a qualifying disposition, to get the benefits of the ISO tax treatment, which Alyssa will discuss, it cannot be disposed of within two years from grant or one year from exercise. Also there's $100,000 per year limitation. In other words, the fair market value employer stock that can be exercised in any calendar year cannot exceed $100,000.

And the example here is that if corporation X grants 100,000 ISOs to B, an employee of X, and they vest over four year period, 25% over the next four years, the fair market value on the grant and the exercise price is $4 per share. Therefore the $100,000 limit has not exceeded since the value of the stock with respect to the ISOs. That first become exercisable is 100,000. So sometimes I see these where ISOs are granted and I've seen the employers not take into account this $100,000 rule, but just keep that in mind. Then they generally become non-quals.

Alyssa Rausch:So to really take advantage of the tax benefits of incentive stock options, you want to make sure that you can get the long-term capital gain treatment. And the reason why this matters is long-term capital gains are taxed at a much lower rate than short-term capital gains and ordinary income. It's taxed at a 20% rate versus a 37% tax rate. So that's a 17% tax savings. So just to step back for just one second, to define long-term capital gains, capital gains are based long-term capital gains result when you sell an asset for more than you buy it for. Now in the capital asset that we're talking about here, is the underlying stock that you purchase from the ISO option. And what makes it long-term for ISOs is a little bit different than what typically would make it, which is typically it's just you need to meet, have held the asset for more than a year.

But for ISOs is a little bit more particular. You have to meet certain holding period requirements and you must not have sold the underlying stock until the later of the expiration of two years from the grant date or one year from the exercise date. Typically the expiration of the two years from the grant date is not as difficult to meet because usually the option doesn't even vest until one year in. So now you're already at the one-year mark into it. So now you just have one more year and a day to go to get the long-term capital gain treatment. One item that I want to point out is that sometimes what gets missed by our clients is that if you have, you can't have a qualifying disposition if you exercise and sell the ISOs underlying stock in the same year, and that would be because you just did not meet the holding period requirements. What that would be considered is a disqualifying disposition, which we're going to discuss later.

So now going into the lifecycle, the way I like to look at these options is that they go through each, to understand stock options I like to look at it as a lifecycle. So this applies to ISOs, non-qualified stock options and also ESPPs, which we're going to discuss in a little bit. And basically at each point in the lifecycle there's a certain tax consequence or no tax consequence as it may be. The lifecycle for ISOs is first you have your grant date, then you have your exercise date, and then your sale date. So at your grant date, that's the date in which the employer simply transfers the ISOs to you. You now have the option to purchase stock, but you haven't purchased stock yet. So naturally there's no tax consequence. At the exercise date, a couple things happen here. For regular tax purposes, there's no tax consequence because all you've done again is at the exercise point, you've simply purchased the underlying stock.

So for regular tax purposes there are no tax consequences, but for the alternative minimum tax purposes, you do have to pick up income and that amount is the fair market value at exercise, less the exercise price. Now the bottom line here is that you're recognizing more income for AMT, alternative minimum tax is another shortened for AMT, but for regular tax you're not. And just to backtrack real quick, for individual income tax purposes, the higher of the AMT or the regular tax is actually the tax you're ultimately subject to. So assume no other AMT or regular tax differences, the higher of the two taxes in this case would naturally be the AMT because you're picking up more income for AMT purposes than for regular tax purposes. So you're stuck at this point.

So where are you here? Here what you have is a couple things going on. One is your basis in the stock that you purchase is higher for AMT than for regular. Why is that? Because your basis for regular tax purposes is just going to be simply the price you paid to buy the stock. For AMT purposes, it's going to be the price you paid plus the income that you picked up. So now you have a higher basis for AMT and a lower basis for regular tax purposes. So you basically carry forward two different basis. You have to keep track of two stock basis. The next thing is you have a couple cashflow issues here because you're actually required to lay out money to buy the underlying stock, but you haven't actually sold it yet, so you don't have the cash yet. So that's one thing to point out.

And also what generates from this is something called a prior year minimum tax credit. What all this credit is, is the amount by which you paid more tax for AMT over regular tax and you're able to carry forward that credit for up to 20 years. The other thing to know about it is that you may only use it to offset the regular tax, not the AMT, which is something that sometimes it could be forgotten in the process. So now we've gotten to the sale date, now you're going to actually sell your underlying stock and you're going to get cash. So two things are going to happen. One, for regular tax purposes, you're going to recognize a long-term capital gain and you're going to pay tax at the 20% rate. For AMT purposes, you're going to recognize a long-term capital gain as well, but your gain that you pick up is going to be lower because you have a higher basis for AMT purposes.

So what happens is, in this case, the regular tax is now higher than your AMT. So since the regular tax is higher, now you get to take that regular tax, offset it against the credit that we just discussed and essentially it just brings you back down to what the AMT is. The other thing I want to note, one more thing is that there is a limitation on the credit whereby you can only take the credit for the spread between the AMT and the regular tax in the year of sale. So just keep that in mind. So in some cases or many cases, you don't always get to fully utilize that AMT credit on the sale. Okay Scott.

Scott Testa:As we go along we'll talk about some payroll tax consequences and they're important because we need to determine if there's any payroll taxes due including federal income tax withholding. So with ISOs, unlike non-quals, if the stock is sold by the employee in disqualifying disposition, there's no deduction to the company, because the employee recognizes a capital gain, a loss on the transaction. If the stock is sold by the employee in a disqualifying disposition, it is compensation income to the employee based on the spread between the fair market value and the exercise price and the employer receives a corresponding compensation deduction. I sometimes find that if the stock is transferred to the employee, the company doesn't always know that the stock is sold and the disqualifying disposition.

But in any case, the employer reports that disqualifying disposition in box one of the employees form W-2 and it's not subject to any withholding FICA, FUTA or federal income tax withholding. And also note that when the stock is transferred to the employee pursuant to the ISO, the employer is supposed to issue form 3921 and furnish it to the employee by January 31st. This reports the fair market value of the ISO exercise, presumably for reporting for AMT purposes. Now let's run through an example here, hopefully we'll clarify some of this. Let's assume on March 13th, 2022, Ash paid $20,000 to exercise in ISO to buy 200 shares of stock worth 200,000. So the exercise price is $100 a share. The fair market value at exercise is $1,000 a share and the spread, therefore $900 a share times 200 shares is $180,000. So for regular tax, the spread of $180,000 is not taxable and his regular tax basis in the stock is what he paid for, 20,000.

But for AMT, Ash must include the $180,000 as an adjustment on the AMT schedule form 6251, there's a line for incentive stock options. And then fees in AMT, which he most likely will be, he's got to pay tax on that $180,000 spread. His AMT basis then becomes $200,000. So you can see the basis differential between the two. All right, now let's move on to the next year. Let's go to the next year. In 2023, look what happens upon sale in a qualifying disposition, the one-year holding period is met and the stock went up by $50 a share or $10,000. And this is the example of using an example as a polling question to save some time. So Bella, do you want to read the polling question?

Bella Brickle:Poll #2

Scott Testa:So this is a sale and the following year and the one-year holding period has been met. Obviously this is a shout-out to, at the time we wrote the slides, Robertson, a member of the band had just passed away, so shout out to him.

Scott Testa:All right, for regular tax, Robbie would recognize a long-term capital gain of 190,000. I see most of you got that right. 210,000 proceeds minus his $20,000 basis. For AMT Robbie would recognize a long-term capital gain of 10,000. His basis was 200,000 for AMT, so he's got a 10,000 long-term gain. He also reports a negative adjustment on the 6251 of $180,000, diverse the prior adjustment from the previous year. So this helps pull him out of AMT and he should be able to use more of his AMT credit when he does this. In the next example, let's assume he sells, it's basically the same example. Now going back to Ash. On January 2023, Ash sells the shares for 150,000 in a disqualifying disposition. So now let's assume that the price went down to 750 share and they're sold in less than one year. So it's disqualifying disposition.

Now remember what happened in 2022, the year of exercise, the year closed. For regular tax purposes spread of 180,000 was not taxable and its basis was 20,000. But for AMT, he had to pick up an ISO adjustment on line 2I of 6251 and his AMT basis is 200,000. Now in 2023 it's a disqualifying disposition. He hasn't held the stock for a year. So for regular tax purposes it's ordinary compensation income. The compensation income is limited to the proceeds, less the exercise price. But for AMT, he was stuck with the $180,000 ISO adjustment on the 2022 return and his AMT basis was 200,000.

Remember he paid 20,000 plus he recognized $180,000 for AMT purposes and he received $150,000 proceeds. He's a short-term capital loss of 50,000. But remember he only gets to take $3,000 on the form 6251 and you'll know we mentioned a difference between regular tax and AMT tax that you have two scheduled D's for regular tax and there's a second schedule D for AMT purposes. The difference goes to form 6251, line 2K. So for regular tax it's compensation income, no capital gain. For AMT, there is no ordinary income because he already paid tax on the spread and there's a short-term capital loss. Assume Ash has no other capital gains, he reports a negative adjustment of 133,000 consisting of 130,000 negative adjustment and a $3,000 AMT capital loss. He also has an AMT capital loss carry forward.

Let's assume instead on January 20th, he sells them in a disqualifying disposition. And again, the recap for regular tax and AMT we went over. For regular tax, he has compensation of income of 180,000, based the $200,000 fair market value and exercise minus the 20,000 he paid for it. And because the amount realized, 250,000 is greater than the valued exercise, he also has a $50,000 short-term capital gain. So $250,000 realized less the basis in stock of 200,000. And for AMT, Ash reports a negative adjustment of 180,000 to reverse out the prior year adjustment. In this example, the AMT basis and the regular tax basis are the same. So there's no further adjustment.

And on the next example, I think we wanted to move this example with a disqualifying disposition in the year of exercise after we discussed some planning opportunities. So Alyssa, you want to talk about some strategies with regard to stock option planning?

Alyssa Rausch:Yes, that would be great. So let's discuss strategy number one. In this strategy you'll essentially follow the code, and what I mean by that is, which just to say we exercise the stock in year one, we sell the stock one year and a day after year one, we then get the long-term capital gain treatment. We pay the lower rate at 20% versus the 37%, everything's great. So you might say, well, why not just follow the strategy? Well it depends on your outlook in the stock. If you expect the stock price to increase, it's a great strategy. If you expect the stock price to decrease however, then you may want to reevaluate. The risks are the following. One is you could actually pay more tax on the AMT spread in year one than you actually collect in the year in which you sell the stock or you might not fully recover it. So that's a really worst case scenario.

Another item is if you don't sell the stock in the same year of exercise, then what happens is you're basically burdened with this income that you picked up on the AMT for AMT purposes but not for regular. So now you're basically locked into this income, that taxable income that you paid and that's it. If the price goes down and it's even less than the purchase price, what Scott was referring to is we would have a capital loss and that's a really bad scenario because it would be for AMT purposes only and you can only offset that loss up to $3,000 against ordinary income per year. So you may never fully utilize the AMT credit. And also Scott has a really good strategy that he uses here and what he says for clients is to exercise early in, let's say January of the year, then see how things are falling into place with the stock price in December and then decide should I sell some of these shares? Should I hold some of these shares? So it's a question of should I exercise and hold or should I exercise and sell?

And then you would basically determine at that point the ones that you want to hold onto would be the ones if you think it would increase in value past what you actually exercise it or purchase it at. I've also seen a lot of clients what they do is they'll exercise each month if it's a very volatile stock and then in December, evaluate what stocks they want to actually sell and create a disqualifying disposition, which we'll talk about in strategy two. Those are just some items to note practically. So for strategy number two, here is where you effectively, purposefully, intentionally disqualify a disposition by selling the stock in the same year of exercise. And when you do this for both regular and AMT purposes, you have to include compensation income equal to the lesser of, and this is an important formula to know if you're working with these, and we modeled this out here.

The lesser of the fair market value at exercise, less exercise price or the fair market value at sale, less exercise price. The lesser of those two amounts is what you have to pick up at income. Now there's no AMT adjustment here because you're doing the same exact thing for regular tax and for AMT purposes. Recalling strategy one, there was no income tax for regular tax, but there was for AMT. Here there is no difference. So there's no AMT adjustment. Now the advantage is you'll have sufficient cash to pay the tax. So sometimes people don't even bother with all of this picking up income in one year and then selling in the next year because they just want to have the cash to pay the tax and also there's less risk and the price fluctuating dramatically because basically typically what happens is you'll exercise the stock and then sell it within a day or two.

The disadvantage is that you will have to pay tax at the 37% tax rate on the income as opposed to the 20%, which is obviously our biggest advantage of strategy one. Now the one thing we do want to point out is we want you to be aware of the wash sale loss rules. So just to backtrack, wash sale rules were put into place for those taxpayers who what they would do is they'd sell stock for a loss and then they'd repurchase the exact stock within 30 days prior to the sale or after the sale. And basically they would try to do that, but the IRS said, you're not allowed to do that, that loss is disallowed, because essentially you're in the same exact position. So why is this relevant here? Well, what happens is that if you sell any shares and they end up in a lost position, then you will have to recognize income at the fair market value, at exercise, less exercise price, regardless if the lesser of those two values is your fair market value at sale.
So you're stuck with picking up that income. Now when I usually see this happen with clients is let's say we have a lot of clients who when they'll have RSUs coming from their employer, they'll have incentive stock options, non-qualified stock options. They have all different types of stock options and it will almost happen by accident in that let's say they'll get delivered restricted stock within that 30-day window and at the same time they dispose of their ISO stock and they don't realize that this happened. So just keep watch for that. Another item I wanted to mention, which Scott did touch upon and I really want to reiterate, is that it sometimes comes to a surprise to taxpayers that when it comes to ISOs that are disposed of in a disqualifying disposition, even though the income is actually reported on the W-2, the income is not subject to income tax withholding.

So just for a practical matter, you have to pay estimates to cover for this income, okay? It's not going to be covered by withholding. So just want to point that one item out. So going into strategy three, so in strategy three, this is kind of a mix, a blended strategy of strategy one and two. And basically what you do is you say, I want to exercise and hold some shares, but I'd also like to exercise and sell other shares. I want a mix and I want to come up with what's known as a break even point. And in this strategy what you do is you determine what the breakeven point is by saying how many shares do I need to sell so that my regular tax is just slightly above my AMT? And so the reason, the benefits of doing this is that you can basically pay tax at an overall rate that's lower than the 37% rate, because some of the tax will be picked up at a 28% and some of it will be picked up at a 37% rate. So you'll have this average rate.

The other reason why it's beneficial is that there's less risk exposure to stock price volatility as in strategy too, because you're selling some of the shares. And then also you get the potential upside of strategy one because you're holding onto some shares and so you could potentially get the benefit of the price going up after exercising.

So Scott, did you want to go into that? You wanted to go back into that example.

Scott Testa:Let go back to that. If you remember that, when you do have ISOs and you are an AMT, you're in this alternate tax universe where you're paying tax on something that's income for AMT, but not income for regular tax purposes, but the top rate is 28%. So if you recognize ordinary income, you're going to be paying 28% as long as you don't pull yourself out of AMT. So as part of the planning, if you have ISOs, maybe you want to disqualify them and pay 28% to take some risk off the table. In other words, a lot of these employees have so much invested in their own company stock subject to volatility, or if you have non-qualified stock options, if you exercise those, you're only paying 28%. But going back to the example where there's this disqualifying disposition in the year of exercise.

Okay, so now Ash, let's say the price went down and the year hasn't ended and the employee sells the stock in the same year of exercise. As Alyssa said, this is a disqualifying disposition. Normally it's a bad move, but you don't want to get caught in the AMT tax trap where you're, one, paying tax on income without any cash inflow or if the stock price goes down and the year closes. So here Ash is limiting his income exposure to the fair market value at sale. Yes, it's compensation income, but the income is measured based on the fair market value at the sale date because the price went down for both regular and AMT. For example, if the price stayed the same at 150,000 and he held the shares for a year, he would've had $130,000 long-term capital gain for regular tax, but he would've paid 28% AMT tax on 180,000 in the previous year.
He would've had an AMT credit carryover, but his $50,000 capital loss for AMT would've been limited to $3,000. So his negative AMT adjustment is limited to $3,000. So he can get whipsawed here. And he doesn't know how long it's going to take to use his capital loss carry forward, just $3,000 a year unless there are gains. He recognizes some gains. It could take him a while for him to be able to use his AMT credit if at all. Since you only get AMT credit to the extent you're out of AMT, it's this negative AMT preference that helps pull you out of AMT so you can use your AMT credit. So that's why it's generally not a good idea if you were to gift ISOs either to charity or to your heirs because that preference never reverses.

So again, this example, there's a positive where it's sold for 150,000, there's a positive adjustment relating to the exercises. It's limited to 130,000. So the basis in stock is $150,000 for AMT, there's compensation of income for 130,000. So now AMT and regular tax are basically the same. So there's no AMT adjustment here, there's no AMT gain or loss and the negative adjustment of $130,000 for compensation income for regular tax, but not AMT, but the two offset each other. So again, this is a way to limit your exposure to income tax if the price goes down. Now for years we've seen stock prices increase, but over the past few years we've had clients exercise ISOs in the 70s and then the share price then dips down to the 20s or 30s. So they might want to consider selling options in the same years of exercise.

All right, next we'll move on to non-qualified stock options. And they're governed by Internal Revenue code 83, which is the transfer of property in connection with the performances of services and it's taxes ordinary income, it's compensation income to the person who performed them. You can grant non-quals to people, independent contractors or board members. It doesn't have to be an employee. With the grant of the non-qual, the taxation of the grant of the non-qualified option depends whether it has a readily ascertain fair market value at grant, but I've never seen options. It's the option itself that has to have a readily ascertainable fair market value at grant, not the underlying stock. So we rarely see that to be the case, but the grant generally there is no tax consequence. Alyssa, you want to handle the next slide?

Alyssa Rausch:Yes. So similar to ISOs, the tax implications of non-qualified stock options also depends on where the options are in its lifecycle. We're going to go through the same kind of lifecycle mapping that we did for ISOs. So on the grant date there are no tax consequences except if what Scott had termed, there's a readily ascertainable fair market value. And just so you understand, that just basically means that the options are actively traded on an established market like the New York Stock Exchange, which we very rarely see. The answer to, would there be tax consequences on the grant date? Most likely not. Okay, so typically on the exercise date is when you would actually pick up the compensation income, which would be equal to the fair market value at exercise, less the exercise price.

And so basically it's tax unfortunately at the 37% rate, remember we're talking about non-qualified now, where we're moving out of the ISO world. The only time in which it wouldn't be on the exercise date is if those options somehow or the stock have a substantial risk of forfeiture. And what this means is that there's some kind of contingency on the stock. Typically you have to have worked for the company for a certain number of years in order to have full rights to it or if there's transferability restrictions, which would mean that you don't have full rights to the stock, you can't sell it, you can't assign it, you can't do it with what you want. So assuming that those are not latched onto it, then you'd be picking up the income on the exercise date. The lapse date just comes into play if either one of those substantial risk of forfeiture or transferability restrictions are in place.

So until those are lifted, then you would have to wait until those lift, which is the lapse date, and then you would just recognize then. Then what would happen is on the sale date, you've exercised the stocks. So now you've bought the stock, you're going to go ahead and sell the stock and you're going to recognize a capital gain in this case equal to the fair market value at sale less basis. And the basis in this case is going to be the amount you paid for the stock plus the compensation income that was recognized early on. So if the stock was held for more than a year, then you can obtain long-term capital gain treatment just like the regular rules and get the 20% rate. If not, then you would have to pick up short-term capital gain. So it's a little bit simpler than the ISO scenario, but it's very common for a lot of people to have non-qualified stock options.

So the next slide we're going to go into, well, we're going to do a polling question to try to test your knowledge on the topic. I'll leave that to you Bella to read.

Bella Brickle:Poll #3

Alyssa Rausch:Okay, so yes, so the answer was C , for those who got that right. So the compensation income will be the $42 per share minus the $20 per share that was purchased at which is $22. So $22 times the 1000 shares, you have $22,000 as your compensation income. And then you're going to have a basis of the $20,000 that you laid out plus the income that you picked up, which was 22,000. So the basis would be 42,000. Okay, so the next one is also a polling question.

Bella Brickle:Poll #4

Alyssa Rausch:So the answer is $6,000 and it is long-term capital gain because you get to take the tack on from the exercise date at whatever that would be the date that you'd start, the one year and a day period. So congratulations on those that did get that right. So now we're going to move into the next slide and this is Scott's slide.

Scott Testa:Sure. Sorry about that. I also want to talk about some stock option planning. Alyssa and I have done stock option planning for executives over the years and we see what happens and I've always run into some of the same issues. The first issue is that stock option planning, I'm telling you it's going to be more about an investment decision than a tax decision. Yes, you want to know what your tax consequences are for exercising either ISOs or non-quals and selling them. But selling it is more often than not is going to be based on an investment decision. And my number one rule of thumb with non-quals is that never exercise and hold non-quals. The opportunity costs are going to kill you. It's not going to be worthwhile. I do say there's a possible exception for private companies because you can't otherwise buy the stock or that's if you can't otherwise buy the stock and you think it's going to take off.

But for publicly traded companies, never exercise and hold them. Look at these opportunity costs. Like we said, non-quals are subject to payroll tax withholding on the spread. So if an employee has a cost to exercise and hold 1,000 non-quals, here's the cost of the exercise and hold 1,000 non-quals of the fair market value, $42,000 and $22,000 of ordinary income. This costs $20,000 to exercise. He's got to pay federal income tax withholding, I just assume 35%. He's got to pay the Medicare tax, I'm assuming he's already over the cap for the social security, he's got to pay state tax on it. He's got to either come up with a check for 29,757 back to the company or sell some shares. I'm saying don't exercise and hold.

If somebody's got to come up with $29,000, he could have taken that and bought 700 shares of the stock and still had the options. So you can keep those in your back pocket. There's also diversification issues. You're so heavily invested in your own company stock. I worked with an executive over at Zoom during the pandemic. This financial advisor brought me in. You saw how the stock, it went up to almost 550, 570,000. The guy got out at like 500,000, he exercised and sold ISOs. He didn't care that he was paying ordinary income tax on it and the price had dropped to double digits. I forget what the exact number was. As I said, an option is an equity interest in the company without any cash outlay. So that's the beauty of these things.

The other example I sometimes give going back to ISOs, is that during the tech boom and the subsequent crash, I had some clients that had exercise. We watched the price of these companies go up and up. Employees were issued stock options in the pennies and the share prices where it was like $200,000. They exercised the options in one year and then in March of 2000 all these dot com companies came crashing down and they were stuck with the AMT preference in the previous year and their shares were basically worthless. Even if they sold the stock, they wouldn't have money to pay the tax. I think even the IRS weighed in on it and said, no, it's clear in the code what the rules are that the year closes and you have to pay the AMT tax. It's like too bad, so sad you got to pay, you have no cash to pay the tax, but that's all part of the planning and minimizing your risk.

Also note that you have the ability to do a stock swap. This is where you take existing shares and use it to pay the exercise price. If you exercise an ISO with previous acquired stock, it will not trigger taxable income unless you use ISOs that don't meet the holding period. The basis in the holding period in the stock used to exercise ISOs carries over to an equal number of shares received in exchange and the excess shares of stock have a basis equal to the income recognized. This code section exists that you can do the stock swap. Although I got to be honest, I don't really see it too often. As the holding period begins on the date the shares are transferred. As I said, the use of the stock, the exercise ISOs will not be a disqualifying disposition unless the ISOs haven't been held for a year.

The exercise, the non-quals with previous acquired shares will also be a tax-free exchange. So just keep that in mind. This is different than doing a cashless exercise, which is something else you can do. Getting back into some planning, as Alyssa mentioned with ISO, AMT breakeven analysis, we do this analysis all the time. One first thing you could do is exercise and hold enough ISOs to break even for AMT, which it's not going to be a lot of shares that you're going to be able to exercise. You probably won't be able to exercise all your ISOs that way because a lot of people are borderline AMT anyway. Another plan is to exercise and hold ISO shares to put you in AMT and then exercise non-quals to break even for AMT purposes. Again, you're paying 28% on something you'd ordinarily pay 37% or whatever bracket you're in.

The next thing I like to do with ISOs in case the price goes down, is to exercise them early in the year, January through April 14th. If the stock depreciates before the end of the year, you reevaluate, you sell them in a disqualifying disposition to limit your compensation element. And if the stock price appreciates by the time you have to pay the AMT tax or your tax that's due on the previous year, you can sell them before the April 15th due date when the tax will be due. You can also do a cashless exercise where you sell enough shares to pay for the exercise of the option and the taxes due. The employees have paid the net amount of the stock, and like I said, a cashless exercise of ISOs will result in a disqualifying disposition of those ISO shares sold. All right, next, I know we have a bunch of questions on stock options so far, but we'll get to them at the end.

I wanted to talk real quick about employee stock purchase plans. Again, this discussion is from the employee's standpoint. I don't know if we need to get into a whole discussion about the qualifications of an employee stock purchase plan. The requirements are set forth under internal revenue code 423B and regulation 1.423-2, which include among other requirements, that the option price cannot be less than the lesser of 85% of the fair market value of the stock of the time the option is granted or 85% of the fair market value at the time the option is exercised. If it meets these requirements, the employees do not have to pay federal income tax on the discount at the time the option to purchase is provided or exercised. Next we'll talk about the employee stock purchase plan lifecycle. Alyssa-

Alyssa Rausch:So again, going back through the lifecycle, the thing that's interesting I find about ESPP, is that you really don't have any tax consequences until the sale date, but it's on the sale date that you determine how much of the income is ordinary versus long-term capital gain. So that's really the play. So just walking you through this, on the grant date, no tax consequence, exercise date, no tax consequence. But then when you get to the sale date, the portion of the gain that's treated is ordinary income versus long-term capital gain, depends on whether or not the income is going to be deemed a qualifying or disqualifying disposition. And qualifying disposition is really the same rules as ISOs in that you have to have not have sold the stock within the two-year period from grant date and the one year from the exercise date.
So you have to meet those criteria. If it doesn't meet those criteria, it's a disqualifying disposition. So what you want to do is you want to treat more income as capital gain and less income as ordinary income because as we said, the differential in the rates of the 20% versus the 37%. So for the qualifying disposition, you only have to pay ordinary income to the extent of the 15% discount. I know another slide, Scott referenced the 85% requirement. So basically the flip of it, the 15% discount is what you will have to pay the ordinary income, the remaining amount of the income gain will be deemed long-term capital gain. In terms of the disqualifying disposition, you have to pick up ordinary income to the extent of the fair market value at exercise, less exercise price, and then the rest of it will be deemed long-term capital gain treatment.

So that's how ESPPs work. And a lot of times clients will come to me in the ask me, well what should I do? How should I handle ESPPs? And even a lot of times they are automatically almost forced to exercise them and they don't know exactly when they should sell. So the way I approach it is it really depends on whether the stock price, again, the outlook of the stock, is the stock price expected to increase or is it expected to decrease? And then I gather from the client the date the stock needs to be sold to make the transaction a qualifying disposition. So just to give you an example of the way I'd approach this is, if we have Rachel Corporation grants Stacey ESPP option shares options on July 1st, 2021. Then Stacey exercises the options on December 31st, 2021.

So in order to meet the holding period requirements, Stacey has to have sold the stock on July 2nd, 2023. If Stacey expects the stock price to increase by July 2nd, 2023 or after, she would want to consider selling because then she can recognize less wage income. If however Stacey thinks the price is going to go down on July 2nd, 2023 or after, then you might want to consider selling as soon as possible. Why? Yes, more income will be classified as wage income, but you'll have more net cash flow than if you wait and the stock price does go down. So a lot of times what happens is there's not as much planning in this area seen, but there is some stuff you can do before you dispose of your ESPP options to consider. And I think Scott, you were going to take over on the qualifying disposition, maybe reiterate some other points.

Scott Testa:A qualifying disposition is a sale more than two years from the date the options were granted and more than one year after the options were exercised. After these rules apply, the employee must have remained an employee of the company at all times. Compensation income is equal to the lesser of, again, this a qualifying disposition, the lesser of the fair market value of the stock at the time the option is granted over the option price or the excess of the fair market value of the stock at the time of the sale over the price paid for the stock. It's not subject to federal income tax withholding FICA or FUTA. And there's a capital gain, which is the excess if any of the sales price of the stock over the employee's basis in the stock. It's capital gain income to the employee. And the basis equals the sum of the amount paid for the option plus the amount included in income as compensation.

A disqualifying disposition is a sale within two years from the date the options were granted within one year after the options were exercised. And I'll get into an example on this. Compensation income is equal to the difference between the fair market value of the stock, the exercise date, less the price paid to exercise the option. There's a difference there. One is based on the fair market value of the exercise and one is based on the fair market value at the sale. It is reported on W-2 in the year of the disposition. It's not subject to FICA, FUTA or federal withholding tax and there's a capital gain. The difference between the basis in the stock and the stock sales price and the employee's basis in the stock equals the sum of the amount paid for the option plus the amount included as income and compensation. Let's get on to polling question number five.

Bella Brickle:Poll #5

Scott Testa:All right, why the odd numbers? This was a real life example. This is a qualifying disposition. So $22 minus 18.70, exercise price 3.30 per share times 704 shares is 2323, just to help you out with some of the math here. And the proceeds, 28.57 a share times 704 shares is 20,113. The basis 18.70, the exercise price plus 3.30 of income recognized, the basis is 15,488.

All right, the answer was A. Most people got that right, right? The compensation income is 2,323 and the capital gain is 4,625. Now what happens in a disqualifying disposition? It's exercised and sold in the same year. So in this example, 27.46 is a fair market value at exercise price 18.70. 27.46 is the fair market value at exercise on June 30th, 22, 18.70 is the exercise price. This compensation income equal to the difference between the fair market value at exercise versus the exercise price. And there's capital gain equal to the difference of the proceeds less the basis of 19,332. Like I said, the difference here is that the compensation income is based on the fair market value at the time of the sale rather versus exercise. So that's the difference in disqualifying disposition.

And I do point out a couple of things, maybe some housekeeping things as I show you one of the last slides on comparison to. That the 1099s are not going to be correct if you have clients that have stock options. The brokers are only required to report to the IRS what they actually paid for the share. So if it's a non-qualified stock option, you're going to see the exercise price on there, not their true cost basis, which you get to add the income that they recognize. Same thing with employee stock purchase plans. It's not going to properly pick up the income that they recognized in the W-2 on the 1099. So keep that in mind.

There's also different rules how states treat stock options, whether states recognize AMT. Also if you're a resident or non-resident rather of a state where you've had options when you worked in and out of a state, like you live in New Jersey, work in New York and you have days in and out of New York, New York's going to want to tax those from grant to vest based on the time you spent worked in New York during that period. A lot of states go based on grant to exercise. There's a lot going on when you're dealing with stock options, not just the federal income tax consequences, but the state consequences as well. I see we're up against our time limit. I know we have a bunch of questions. We'll try to answer them individually. In this case I'll turn it over to Bella.

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