You can exchange stock in your employer to pay for the exercise of your incentive stock options.
December 19, 1998
Date: Sat, 19 Dec 1998
What are the advantages or disadvantages of purchasing shares of an employer’s stock (either through an employee stock purchase plan or on the market) and using those shares to later satisfy the exercise price under an ISO? How are the holding periods and basis calculated?
The advantage of exchanging previously-acquired employer stock to satisfy the exercise price of an ISO is the tax for any gain on the surrendered stock is deferred until the option shares are sold. This procedure is called a swap. (Remember that shares of stock acquired using another ISO or through an employer stock purchase plan that haven’t met the holding period requirements aren’t eligible for this type of exchange.) This seems especially attractive when the employee doesn’t have the cash to exercise incentive stock options.
The disadvantage is that if the employee could otherwise finance exercising the ISO, the employee will have fewer shares of employer stock if he or she exchanges shares.
For example, if an employee surrenders 10 shares with a fair market value of $50 per share to acquire 100 shares with an option price of $5 per share, the employee will have 100 shares (of course). If the employee kept the 10 shares and paid $500 cash for the 100 shares, the employee would have 110 shares. If the market value of the stock doubled to $100 per share, the employee in the first scenario would have an asset value of $10,000. The employee in the second scenario would have stock worth $11,000 less the $500 cash invested, or $10,500.
An equal number of the acquired shares take the acquisition date and tax basis of the surrendered shares. The tax basis of the additional shares acquired when exercising the ISO is zero, and the acquisition date is the date of exercise (unless restricted stock rules apply.)
For example, Jane Employee has 100 shares of Supergrow stock with a total fair market value of $5,000 ($50 per share), for which she paid $50, or $.50 per share. She has an incentive stock option to purchase 5,000 shares of Supergrow stock for $1 per share. If Supergrow permits it, Jane may surrender her 100 shares and receive 5,000 shares in return. Her tax basis in the shares will be $.50 per share, the basis of the shares surrendered, for 100 of the shares, and zero for 4,900 shares. She will have no taxable gain or loss for the exchange. She will still report a tax preference of $250,000 (value of shares received) – $5,000 (option price) = $245,000 in computing the alternative minimum tax for the year of exercise. She must still hold all 5,000 shares for more than two years after the date of grant and more than one year after the date of exercise in order to avoid reporting ordinary income for the spread on the date of exercise.
For more details about incentive stock options, request a copy of our free report, Incentive Stock Options – Executive Tax and Financial Planning Strategies.