During a cashless exercise, the employee exercises the option to purchase shares, but does not pay anything to do so. Here is how the process works:
- The employee exercises the option to purchase a quantity of shares.
- Pursuant to the purchase of stock, a quantity is sold sufficient to pay for transaction costs and any tax bill associated with the transaction.
- The employee nets any stock or cash remaining after the sale and payment of expenses associated with the stock's acquisition.
- Cashless exercise would receive favorable tax treatment so long as the employee holds the shares for at least one year from the exercise date and two years from the grant date. Failure to adhere to these requirements would constitute a disqualifying disposition causing the employee to recognize as ordinary income the bargain element (the extent to which the option is in the money).
For example, Nigel Stone receives 5,000 incentive stock options from his employer to buy company shares at $12 per share. He exercises the options when the stock's current market value is $20 per share. A number of years later, past the two year window on the grant date and the one year from the exercise date, he sells the shares at $50 per share.
The tax implications of the foregoing are as follows.
- The grant of the options entails no taxable event.
- No additional ordinary income arises from the exercise of the options, but Stone will incur an alternative minimum tax adjustment upon exercise of the options for $40,000 (($20-$12) x 5,000) and possibly cause him to pay AMT.
- Stone's long term capital gain would be $190,000 ($250,000 - $60,000). Adjusted taxable basis would be $12 per share.
- Stone's capital gain for AMT purposes would be $150,000 upon the sale of the shares at $50.
$250,000-$100,000 (adjusted basis would be $20 per share, $12 is the strike price and $8 is the AMT adjustment for the amount by which the option was in the money at exercise.)
- Sale of the shares in the same calendar year as exercise would result in W-2 income of 5,000 x ($20-$12) = $40,000.
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