The Nightmare Of A Market Decline With Employee Stock Options

September 29, 1998
© 1998 by Michael C. Gray

One of worst scenarios for an employee who exercises an employee stock option is for the value of the stock to fall dramatically in a later year.

The reason is the employee must pay taxes on non-cash income. The employee may have to raise the cash from other sources to pay the tax.

To illustrate the effect of a market decline for an employee, I created some federal tax projections under several scenarios.

The taxpayer is a single person with wages of $100,000, who only claims one personal exemption and the standard deduction.

In 1998, the taxpayer exercises a stock option with the difference between the option price of the stock and the fair market value of the stock of $200,000. In 1999, the taxpayer sells the stock for its option price. (In other words, the market has erased the appreciation that existed in 1998.)

If the taxpayer only reported wages income of $100,000 for 1998 and 1999, the total federal income tax would be about $47,400.

If the taxpayer exercised an incentive stock option, the total federal income tax for 1998 and 1999 would be about $80,500. The taxpayer would have $33,000 of minimum tax credits available to reduce regular tax liabilities in a later year. $23,700 of the credits would have been used in 1999.

If the taxpayer exercised a non-qualified stock option, the total federal income tax liability for 1998 and 1999 would be about $118,328. The taxpayer would have an $197,000 unused capital loss carryover to be applied in a later year. Clearly this taxpayer had little to lose by selling at least some of the stock when the option was exercised.

What would happen if the taxpayer sold some additional stock for a $200,000 long-term capital gain in 1999?

If the taxpayer only reported wages income, the taxpayer would have a total income tax liability for 1998 and 1999 of about $89,700.

If the taxpayer exercised an incentive stock option, the taxpayer would have a total income tax liability for 1998 and 1999 of $93,750. The taxpayer would have about $5,500 of minimum tax credits to be used in a later year.

If the taxpayer exercised a non-qualified stock option, the taxpayer would have a total income tax liability for 1998 and 1999 of $97,725. The $200,000 capital gain would absorb all of the capital losses from the option shares.

What lessons have we learned from this exercise?

Market risk should be a concern when tax planning for employee stock options.

Employees who exercise non-qualified stock options should seriously consider selling at least enough of the shares they receive to pay the income taxes they owe.

If the value of the shares has declined when they are sold, the employee should seek other sources of income, particularly capital gains, to use capital losses for shares purchased using non-qualified options and minimum tax credits for shares purchased using incentive stock options.

Getting professional tax help to plan for exercising and selling stock purchased using employee stock options is a worthwhile investment!

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