Can I avoid or defer taxes on the spread between the exercise price and the market value on non-qualified stock option shares?
January 17, 1999
Subject: Deferring Taxes for Non-Qualified Stock Options
Date: Wed, 23 Dec 1998
I have a non-qualified stock option plan (NQSO) that permits me to tender existing shares in order to pay for exercising the option. For example, if I own 10 shares and the market price is $20 per/share, I can tender those shares as $200 towards the payment of the option. I have two questions:
- Do I have to pay taxes on the capital gains for the tendered shares (the 10 shares tendered at $20/share which I originally bought at $5/share)?
- Is there any way for me to avoid or defer paying tax on the spread between the exercise price and the market value on the shares I will receive as a result of exercising the option?
- You do not pay income taxes for surrendering shares of company stock to exercise a non-qualified option. (Unless the shares surrendered were acquired using an incentive stock option and the shares were surrendered within 2 years after grant or 1 year after exercise of the ISO.) The exercise is a tax-free exchange under Internal Revenue Code Section 1036(a).
You will pay tax for ordinary income based on the spread between the fair market value of the stock and the option price on the date of exercise.
The tax basis of an equal number of shares to those surrendered will have a “substituted basis” equal to the basis of the surrendered shares and will have the same acquisition date as the surrendered shares.
For example, your 10 shares are surrendered at a fair market value of $20 per share to exercise a non-qualified option for 100 shares with an option price of $2 per share. (Assume the tax basis for the existing shares is $5 per share.)
The ordinary income reported will be:
Fair market value – 100 X $20 $2,000 Option price – 100 X $2 200 Ordinary income $1,800
- Tax basis of shares received:
90 “new” shares – based on ordinary income – 90 X $20 $1,800 10 “replacement” shares – substituted “old” basis – 10 X $5 50 Total $1,850
- The only thing that could postpone the recognition of income when you exercise the option is if the stock received is non-vested or otherwise subject to a substantial risk of forfeiture. If the stock appreciates, this will result in your reporting more ordinary income when the restrictions or risk of forfeiture lapses.
You might be able to mitigate the effect of reporting the income using income-shifting strategies. This is beyond the scope of my response.