Exchange of Shares in ISO Exercise

Editor: Alan Wong, CPA

Gross Income

Incentive stock options (ISOs) are granted to a corporation’s employees and provide the privilege of purchasing the company’s stock at a fixed price during a specific time frame. Under Regs. Sec. 1.6045-1(d)(2), which requires that broker statements disclose securities’ adjusted basis beginning January 1, 2011, basis tracking of ISOs is more relevant than ever.

Example 1: F, a single employee of ABC, Inc., receives ISOs in June 2006 to purchase 1,000 shares of ABC stock at $20 per share. F exercises her stock options in September 2007 when the stock’s fair market value (FMV) is $50 per share. F pays $20,000 cash ($20 option price × 1,000 shares) for stock worth $50,000 ($50 FMV × 1,000 shares).

Given that certain requirements provided for in Sec. 422 are met, under Sec. 421(a) there is no income tax result upon exercise of an ISO. For regular income tax purposes, F will not have any income tax ramifications upon receipt of the stock, and her cost basis is $20,000 ($20 per share).

In determining her alternative minimum taxable income (AMTI), F will incur an additional $30,000 ISO adjustment as required by Sec. 56(b)(3), and her AMT cost basis will be $50,000 ($50 per share).

Example 2: In December 2007, F receives another ISO to purchase 1,000 shares at $36 per share. She exercises this option in January 2009 when the stock value is $60 per share. F swaps 600 shares of her ABC shares purchased in September 2007, valued at $36,000, to purchase an additional 1,000 shares. After the swap, F owns 1,400 ABC shares.

Regs. Sec. 1.422-5(b) provides for cashless exercise of incentive stock options under Sec. 1036(a), which allows nonrecognition treatment in an exchange of common stock for common stock of the same corporation. Regs. Sec. 1.422-5(b)(3)(i) provides for transferred basis in the options received under the Sec. 1036 exchange and for holding period determination under Sec. 1223. F’s cost basis and holding period in the 600 shares she acquired in September 2007 will transfer to the first 600 shares she received in the swap.

Regs. Sec. 1.422-5(b)(3)(ii) provides that since F did not pay for the additional 400 shares received in this transaction, she will have zero basis in these shares, and her holding period begins on the exercise date. (See Exhibit 1.)

Under Sec. 56(b)(3), the FMV of the excess 400 shares F receives (1,000 shares received less 600 shares given up) is treated as compensation for AMT and will give rise to an AMT adjustment of $24,000 ($60 FMV × 400 shares). (See Exhibit 2.)

F should consult with her tax adviser before exercising her options or selling her ISO shares. Their discussions may include the following:

• The AMT cost of the ISO adjustment is most egregious for middle-income taxpayers in the 28%–33% marginal tax brackets. If possible, F should exercise her ISOs in a year in which she can avoid or mitigate the AMT cost. For purposes of the calculation in Exhibit 3, personal exemptions are ignored, the taxpayer is single, the taxpayer takes the standard deduction, and 2011 tax rates are used.
• A cashless exchange or swap can be used to increase F’s shares in ABC, defer gain on appreciated previously acquired ISOs, and avoid cash outlay. A swap when the FMV is relatively low will require giving up more shares and result in a smaller AMT adjustment, while a swap when the FMV is relatively high will require fewer shares in the swap but will ultimately result in more ownership and a larger AMT adjustment.
• To qualify the disposition of ISO stock for the most preferential tax treatment (long-term capital gain), F should hold the stock for two years from the option grant date and one year from the option exercise date in accordance with Sec. 422(a)(1).

EditorNotes

Alan Wong is a senior manager at Holtz Rubenstein Reminick LLP, DFK International/USA, in New York, NY.

For additional information about these items, contact Mr. Wong at (212) 697-6900, ext. 986, or awong@hrrllp.com.

Unless otherwise noted, contributors are members of or associated with DFK International/USA.