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On November 1, 2017, I am granted 80,000 ISOs that vest over four years (with a one year cliff). The strike price is $3.

On November 1, 2018, 20,000 of the options vest. The FMV has grown from $3 to $5.

I opt to utilize the following clause in the option agreement:

Payment of the Exercise Price can be done by surrendering of other Shares which (i) shall be valued at its Fair Market Value on the date of exercise, and (ii) must be owned free and clear of any liens, claims, encumbrances or security interests, if accepting such Shares, in the sole discretion of the Administrator, shall not result in any adverse accounting consequences to the Company.

Questions:

  1. What is the maximum # of shares I can own without spending any cash out of pocket?
  2. What will my tax liability be?
  • 2
    You forgot to tell us where you are located for tax purposes. – ChrisInEdmonton Oct 13 '17 at 13:54
  • by "using the other 10,000 vested options" do you mean selling them? – D Stanley Oct 13 '17 at 13:57
  • That highly depends on the fair market value of the options at time of exercise. What's that? – Hilmar Oct 13 '17 at 16:30
1

I've never heard of an employer offering this kind of arrangement before, so my answer assumes there is no special tax treatment that I'm not aware of. Utilizing the clause is probably equivalent to exercising some of your options, selling the shares back to your employer at FMV, and then exercising more options with the proceeds. In this case if you exercise 7500 shares and sell them back at FMV, your proceeds would be 7500 x $5 = $37,500, with which you could exercise the remaining 12,500 options. The tax implications would be (1) short-term capital gains of 7500 x ($5 - $3) = $15,000 and (2) AMT income of 12,500 x ($5 - $3) = $25,000, assuming you don't sell the shares within the calendar year.

0

This may be a good or a bad deal, depending on the fair market value (FMV) of the stock at the time of exercise. Let's assume the FMV is $6, which is the break even point.

In general this would probably be treated as two transactions.

  1. You exercise 10k stock at 3$ and immediately sell it back to the company (or anyone else for that matter) for $6/share. This will generate $30.000 of "compensation income" for both regular and AMT purposes.
  2. You use the cash from the first transaction to exercise another 10k of stock at $3 a share and keep them. That generates no income for regular tax but another $30,000 of compensation income for AMT

So overall you would be cash neutral, but your regular tax income would be increased by $30,000 and your AMT income by $60,000.

  • In step 1, there would be no AMT compensation income because you're selling within the same year. There would only be short-term capital gains (for both regular and AMT income purposes). In step 2, there would be AMT compensation income assuming you don't sell the shares within the same year. – Craig W Oct 13 '17 at 19:09
  • I don't think that comment is correct. The difference between exercise and strike price is compensation income for both regular tax and AMT. Short term capital gain would only occur if there is a difference between the sell price and the exercise price – Hilmar Oct 14 '17 at 23:20
  • The difference between exercise and strike price is definitely not counted as income under the regular income tax system. It is for AMT unless you sell within the same calendar year, as is the case here for the first part of the shares. There are short-term capital gains under regular income tax here because their basis is $3/share and they're selling at $5/share. No short-term capital gains under AMT because their AMT basis is $5/share. – Craig W Oct 14 '17 at 23:52
  • Previous comment should have read "difference between exercise price and FMV", not "exercise and strike price", as these two are the same thing. I assume that's what you meant also. – Craig W Oct 15 '17 at 0:00
  • Sorry, I was sloppy with my definition: Exercise price = Stock price at time of exercise, Fair Market Value or Actual Price. – Hilmar Oct 16 '17 at 0:49
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That is a weird one. Typically one never needs to layout cash to exercise an option. One would only choose to use option 1, if one is seeking to buy the options. This would occur if an employee was leaving a company, would no longer be eligible for the ISO (and thereby forfeit any option grant), and does not want to exercise the options.

However, what is not weird is the way income tax works, you are taxed on your income in the US. I assume you are talking about the US here.

So if you exercise 10K shares, if under either option, you will be taxed on the profit from those share.

Profit = (actual price - strike price) * shares - fees

  • 1
    I've certainly had the opposite experience: no cash = no stock, unless it's a same day transaction. Point taken, though. I will delete my original comment as it's too assertive. – Hilmar Oct 13 '17 at 16:49
  • It seems you don't understand the tax treatment of ISOs. There is a significant tax benefit to a cash exercise. – prl Jan 12 '18 at 5:08

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