Employee Stock Options - Cashless Exercise of ISOs

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:

  1. The employee exercises the option to purchase a quantity of shares.
  2. Pursuant to the purchase of stock, a quantity is sold sufficient to pay for transaction costs and any tax bill associated with the transaction.
  3. The employee nets any stock or cash remaining after the sale and payment of expenses associated with the stock's acquisition.
  4. 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.

  1. The grant of the options entails no taxable event.
  2. 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.
  3. Stone's long term capital gain would be $190,000 ($250,000 - $60,000). Adjusted taxable basis would be $12 per share.
  4. 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.)
  5. 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.
Non-Qualified Stock Options


Related Articles
  1. Executive Compensation

    Get The Most Out Of Employee Stock Options

    Many corporations encourage employees to participate in the company’s growth by offering them a piece of the pie. That means employee stock options.
  2. Options & Futures

    How Are Stock Options Taxed & Reported?

    That depends on the type of stock option you have. A rundown of the tax treatment for statutory and nonstatutory, or non-qualified, options.
  3. Professionals

    Possible Outcomes For An Option

    Exercised If the option is exercised, the buyer has elected to exercise their rights to buy or sell the stock depending on the type of option involved. Exercising an option obligates the seller ...
  4. Investing Basics

    Introduction To Incentive Stock Options

    Here are some basic highlights of how ISOs work and the ways they can be used.
  5. Professionals

    Incentive Stock Options

    CFP Online Study Guide - Employee Benefits Planning - Incentive Stock Options
  6. Professionals

    Sale of Incentive Stock Options

    CFP Online Study Guide - Employee Benefits Planning - Sale or Disposition of incentive stock options
  7. Professionals

    Calls And Puts

    Calls And Puts
  8. Options & Futures

    Employee Stock Options: Premature Exercise Risks

    By John Summa, CTA, PhD, Founder of HedgeMyOptions.com and OptionsNerd.comTaxes are never a fun, or funny, topic but when you can demonstrate how much you can defer and ultimately reduce in taxes ...
  9. Options & Futures

    4 Reasons To Hold Onto An Option

    There are times when an investor shouldn't exercise an option. Find out when to hold and when to fold.
  10. Professionals

    Tax Treatment of Options

    Tax Treatment of Options
RELATED TERMS
  1. Early Exercise

    The exercise of an option prior to its expiration date. Early ...
  2. Exercise Price

    The price at which the underlying security can be purchased (call ...
  3. American Option

    An option that can be exercised anytime during its life. American ...
  4. Call Over

    When the buyer of a call option exercises the option. In options ...
  5. Exercise Backdating

    A practice where option holders fraudulently claim to have exercised ...
  6. Cashless Exercise

    A transaction that is used when exercising employee stock options ...
RELATED FAQS
  1. After exercising a put option, can I still hold my option contract in order to sell ...

    Once a put option contract has been exercised, that contract does not exist anymore. A put option grants you the right to ... Read Answer >>
  2. How do I change my strike price once the trade has been placed already?

    Learn how the strike prices for call and put options work, and understand how different types of options can be exercised ... Read Answer >>
  3. What are the SEC regulations on exercising stock options?

    Learn how the SEC and IRS regulate employee stock options, including the exercise of options and the sale of options, and ... Read Answer >>
  4. How is a put option exercised?

    A put option is a contract that gives the option holder the right, but not obligation, to sell a set amount of shares (1 ... Read Answer >>
  5. When holding an option through expiration date, are you automatically paid any profits, ...

    Holding an option through the expiration date without selling does not automatically guarantee you profits, but it might ... Read Answer >>
  6. I've noticed executives buy a lot of stock below market value, and then they sell ...

    On October 30, 2006, a Google executive officer purchased 2,541 shares of Google at $9 per share and sold these same shares ... Read Answer >>
Hot Definitions
  1. Return On Invested Capital - ROIC

    A calculation used to assess a company's efficiency at allocating the capital under its control to profitable investments. ...
  2. Law Of Demand

    A microeconomic law that states that, all other factors being equal, as the price of a good or service increases, consumer ...
  3. Cost Of Debt

    The effective rate that a company pays on its current debt. This can be measured in either before- or after-tax returns; ...
  4. Yield Curve

    A line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity ...
  5. Stop-Limit Order

    An order placed with a broker that combines the features of stop order with those of a limit order. A stop-limit order will ...
  6. Keynesian Economics

    An economic theory of total spending in the economy and its effects on output and inflation. Keynesian economics was developed ...
Trading Center