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Date:   Tue, 4 May 2004
From:   Daniel

My understanding of a stock swap exercise of ISOs is that the exchange shares maintain their original cost basis and acquisition date, while the newly acquired shares receive a basis of $0.

I believe if I were to sell the new new shares before one year after exercising that it would create a disqualifying disposition and I would have to pay ordinary income tax. What happens if I sell the exchange shares? Would that create a disqualifying disposition too?

Answer

Date:   Fri, 28 May 2004

Hello Daniel,

No. Only the sale of the "new" shares will result in a disqualifying disposition. The old shares keep their characteristics, including basis and acquisition date.

According to the regulations, for the purposes of determining a disqualifying disposition, the holding period for all of the shares (including the exchanged shares) are considered as starting on the date of exercise. More importantly, according to regulations section 1.422-5(b)(2), "...the optionee's disqualifying disposition of any of the stock acquired through such exercise is treated as a disqualifying disposition of the stock with the lowest basis." In other words, the regulations specify an ordering rule for the disposition of shares. The shares for which ordinary income would be recognized are considered sold first.

Here's an example, loosely based on one in the regulations. On June 1, 2004, X Corporation grants an incentive stock option to employee A to purchase 100 shares of X Corporation common stock at $10 per share. A may swap other shares of X Corporation stock to exercise the option. A owns 40 shares of X Corporation common stock, purchased on the open market on June 1, 2002 for $5 per share. On June 1, 2005, when the fair market value of the shares is $25 per share, A swaps his 40 shares to exercise the ISO.

The tax basis for 40 shares is $5, with an acquisition date of June 1, 2002. The tax basis for 60 shares is zero, with an acquisition date of June 1, 2005.

On September 1, 2005, A sells 75 of the shares for $30 per share. A is considered first selling the 60 "new" shares and recognizing the related ordinary income of $1,500. ($25 FMV at exercise - $0 tax basis = $25 ordinary income per share X 60 shares = $1,500. Note this equals $25 FMV - $10 option price = $15 ordinary income per share X 100 shares for ISO = $1,500.) The short-term capital gain for the "new" shares is $30 - $25 = $5 per share X 60 shares = $300. The long-term capital gain for the "old" shares is $30 - $5 = $25 per share X 15 = $375.

For alternative minimum tax reporting, $1,500 ordinary income is reported relating to the exercise of the ISO. ($25 FMV - $0 cost = $25/share X 60 shares = $1,500.) It appears to me you should follow the shares considered to be sold for regular tax purposes in determining AMT reporting and adjustments. Therefore, the short-term capital gain for the "new" shares is $30 sales price - $25 FMV at exercise = $5 per share X 60 shares = $300. The long-term capital gain for the "old" shares is $30 - $5 = $25 per share X 15 = $375. Note that the regular tax and AMT amounts are the same because the "new" shares were sold during the year of exercise. There are no AMT adjustments.

Now that I've explained this, here's an editorial note. The swap to exercise is a "gee whiz" technique that usually isn't so great. Why? Because you still have to pay the alternative minimum tax for exercising the option. Under the current tax regime, with a 35% maximum federal regular tax rate and a 28% maximum federal AMT rate, it just isn't worth taking much risk to hold onto the shares to meet the holding period requirements when you're dealing with big amounts, especially when your state has a high income tax rate, like California. Throwing in the "ordering rules" that require the "ordinary income" shares to be sold first makes this technique even less attractive. Also, if you expect the value of the shares to increase dramatically, you will benefit more by not swapping shares because you will own more shares without a swap.

Good luck!

Mike Gray

For more information about incentive stock options, request our free report, Incentive Stock Options - Executive Tax and Financial Planning Strategies.

IRS Circular 230 Disclosure: As required by U.S. Treasury Regulations, you are hereby advised that any written tax advice contained in this answer was not written or intended to be used (and cannot be used) by any taxpayer for the purpose of avoiding penalties that may be imposed under the U.S. Internal Revenue Code.