Employees or other service provider stock option recipients (“optionees”) frequently have the following question:
Is there a way for me to obtain capital gains treatment on my stock options?
The short answer is: Not without some pain and difficulty.
Stock options, if priced at fair market value, are not taxable upon receipt. This is the good news.
The bad news is that to start the capital gains holding period, an optionee must exercise the option. And to actually achieve long term capital gains treatment the optionee must exercise the option and hold the stock for more than 1 year (in the case of a non-qualified stock option, and perhaps longer in the case of an incentive stock option) (ISO holders must actually meet two holding periods; they must hold the shares for 1 year after exercise and for 2 years from the date of grant of the option; see Section 422 of the Internal Revenue Code.)
Exercising a stock option other than in connection with a liquidity event to start the capital gains holding period is typically problematic for a number of reasons.
First, to exercise, the optionee is going to have to pay the exercise price. Sometimes the exercise price alone is outside of the financial ability of the optionee. Can the optionee borrow the exercise price from the issuer? The borrower would have to approve, and the borrower may not be able to make loans available to its optionees for a variety of reasons, but in order to start the capital gains holding period the optionee will have to be fully liable for the amount of the note; meaning, that in the event of the bankruptcy or insolvency of the company, a bankruptcy trustee or other fiduciary could be chasing the optionee, enforcing the terms of the note despite the fact that the stock acquired by executing the note was then worthless.
Second, usually options are only exercisable once they vest. Meaning, an optionee is not typically going to be able to exercise their stock option upon grant. They are going to have to provide service for some period of time first, thus delaying their ability to exercise to start their capital gains holding period.
Finally, upon exercise, if the value of the shares received exceeds the purchase price, they are going to have to pay taxes in addition to the exercise price. If an option is an “incentive stock option,” the spread is an alternative minimum tax adjustment, which frequently gives rise to a tax owing on an optionee’s individual tax return (and not infrequently an unusually uncomfortable amount of tax). If an option is nonqualified stock option (meaning, not an ISO), then the spread is subject to income and wage withholding.
This leaves many optionees in the position of not being able to afford to exercise prior to a liquidity event because the combined economic burden of the exercise price and the taxes owing on exercise is too great. Exercises in connection with a liquidity event will not entitle the optionee to capital gains treatment because the holding period will not have been met.
What about ISOs, you might ask. Isn’t is true that if I receive an ISO, and I meet the holding period requirements, that my gain on the ultimate sale of the stock is capital gain? The answer is yes–but again with the following caveats. First, you are going to have to exercise the option, pay AMT (probably), and hold the stock for at least 1 year after exercise and for at least 2 years after the option grant. The AMT hit might surprise you. You may not be able to afford to exercise because of the size of the AMT hit unless you exercise in connection with a liquidity transaction –in which case you won’t meet the holding period requirements required to achieve the purported ISO tax benefit of paying only capital gains on the disposition of the stock.
What can employees who desire better tax treatment for their options do? Not be trite–but pester lawmakers to make it easier and less burdensome from a tax perspective for employers to share equity with employees and other service providers. If the AMT exemption amount was increased substantially, this would make ISOs substantially more attractive and potentially substantially alleviate the problems I’ve described here at least with respect to employees. In general though, I think that the tax law of stock options needs to revisited and revised. Section 409A, especially as it applies to startup and small companies, ought to be repealed, once again allowing discounted stock options to be used without difficulty. What Congress did in enacting 409A was hamper the ability of companies to share equity with employees–putting another hurdle on the road of the innovation economy.