Subject: Tax Code - Cashless Option Exercise

Last-Revised: 9 Feb 2009
Contributed-By: Art Kamlet (artkamlet at aol.com), Chris Lott (contact me)

This article discusses the tax treatment of an employee's income that derives from stock options, specifically the case in which an employee exercises non-qualified stock options without putting any money down.

First, a digression. What is a non-qualified option? A non-qualified stock option is the most popular form of stock option given to employees. Basically, an employee who exercises a non-qualified option to buy stock has to report taxable income at the time of the purchase, and that income is taxed as regular income (not as a capital gain). In contrast, an incentive stock option (ISO) dodges these tax bullets, but is more complicated because employees who receive ISOs have to worry about alternative minimum tax (AMT). Unfortunately some companies are sloppy about naming, and use the term ISO for what are really non-qualified stock options, so be cautious.

Next, what is a cashless exercise? Basically, this is a way for an employee to benefit from his or her stock option without needing to come up with the money to purchase the shares. Any employee stock option is basically a call option with a very long expiration; hopefully it's also deep in the money (also see the FAQ article on the basics of stock options). When a call option is exercised, the person who exercises it has to

pay to buy the shares. If, however, the person is primarily interested in selling the shares again immediately, then a cashless option becomes interesting. The company essentially lends the person the money needed for the option exercise for the fraction of a second that the person owns the shares.

In a typical cashless exercise of non-qualified stock options (you can tell it is non-qualified because the W-2 form suddenly has a huge amount added to it for stock option exercise), here is what happens. Let's use E as the Option Exercise Price and FMV as the fair market value of the shares. The employee needs to pay E as part of the option exercise. But this is a cashless exercise, so the company (or, more likely, a broker acting as the company's agent) lends the employee that amount (E) for a few moments. The stock is immediately sold, for FMV. The broker takes back the amount, E, loaned to the employee for the exercise, and pays out the difference, FMV-E. The broker will almost certainly also charge a commission.

Ok, now for those fortunate people who are able to do a cashless stock option exercise, and choose to do so, how do they report the transaction to the IRS? The company imputes income to the employee of the difference between fair market value and exercise price, FMV-E. That amount is added to the employee's W-2 form, and hopefully shows up in Box 12 indicated by a V. The amount FMV-E is the imputed income. Again, you will notice FMV-E is not only what the broker paid out, it is also the imputed income amount that shows up in the W-2 form.

The Schedule D sales amount reported by the broker is FMV minus any commission. The employee's cost basis is the FMV. So the FMV is the sales price, and the Schedule D for this transaction will show zero (if no commission was charged) or a small loss (due to the commission).

In certain situations, FMV might differ slightly from the price at which the shares were sold, depending on how the company does it, and if so, the company should report the FMV to the employee. Then the Schedule D must be completed appropriately to show the short-term gain or loss (the difference between the sales price and FMV).

For extensive notes on stock and option compensation, visit the Fairmark site with articles by Kaye Thomas:
http://www.fairmark.com/execcomp/index.htm

Julia K. O'Neill offers an extensive discussion of the differences between incentive stock options and non-qualified options:
http://www.feinberglawgroup.com/StockOptions.html

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