Employee Stock Options and Alternative Minimum Tax (AMT) - John R. Dundon II, Enrolled Agent
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Employee Stock Options and Alternative Minimum Tax (AMT)

Employee Stock Options and Alternative Minimum Tax (AMT)

Okay this is fun, writing about employee stock options that is. The biggest thing that kicked me in the jimmy as it were was the Alternative Minimum Tax (AMT) obligation associated with Incentive Stock Options that were exercised (converted to stock) but the underlining stock was not sold in the same tax year that the option was exercised.  Holy mother of God this can be an expensive tax liability that requires a LOT of out of pocket cash to satisfy. The lesson I learned was that because of AMT liability be prepared to pay a substantial tax liability if you exercise stock options and hang onto the underlying stock until a future tax year. In other words if you hold the stock after exercising the option the difference between income tax and capital gains tax is essentially mitigated because of the AMT liability associated with exercising options and not selling the stock in the same tax year can be so onerous it is borderline abusive if not outright extortion like.

The absolute best scenario in my opinion is to exercise stock options at the beginning of the tax year, recognize the strike price as ‘income’ for tax purposes; watch the value of the stock appreciate; and then before the end of the tax year sell the underlining stock and recognize the difference between the option exercise price and the stock sales price as a capital gain subject to capital gains tax liability, in theory foregoing AMT liability.  Keep in mind that this could also result in a capital loss situation as well reported on Schedule D.

An option provides its holder the right to purchase a certain amount of equity of the company at a fixed price (the “strike price”) at some point in the future. An option may be favored by the company because it does not grant the holder with any statutory or non-statutory rights, at least not until the option is exercised and the option holder becomes an equity holder. Further, unless the company’s equity appreciates to a level that exceeds the strike price before the option expires, the holder will have no immediate financial incentive to exercise the option. Thus, the option may never be exercised.

When an employer grants an employee with equity that is fully earned or “vested” on the date granted, the employee is treated as if he or she received an amount of compensation from the employer equal to the fair market value of the equity as of the date of grant.

The employer can subject the equity grant to a “substantial risk of forfeiture.” Equity is subject to a substantial risk of forfeiture if the equity will be forfeited in the event that the employee’s employment ends prior to the end of the vesting period (typically two to four years). Once this restriction lapses, the equity will be deemed earned (“vested”) and the employee will incur a tax liability. Vesting provisions can be prorated over time so the employee does not incur the entire tax liability at once. This would entail allowing the employee to earn a portion for each month or quarter over which the employee’s employment period extends. This type of vesting allows the employee to pay tax on the award over a period of two or more years rather than being taxed on the full amount in the year of the grant.

If the employee receives options, the employee generally will not realize an immediate income tax liability as of the date of grant provided that the strike price of the option is at or above fair market value as of that date. Once the employee exercises the option, however, the employee will likely realize ordinary income equal to the value of the exercised options.  The difference between the strike price of the option and the fair market value of the stock as of the date of exercise would be recognized as capital gains when the stock is sold. If the option is exercised and the stock is held over to a future tax year the employee may be subject to Alternative Minimum Tax (AMT) on the difference between the option strike price and the fair market value of the stock at the end of the tax year. If the equity received upon exercise of the option is subject to a substantial risk of forfeiture though, the employee is not required to recognize any taxable income until the equity is vested.

Regardless of whether equity is obtained through a direct equity grant, a vesting schedule or the exercise of an option, the gain resulting from such grant or exercise is treated as “ordinary income” for federal income tax purposes. When and if the employee subsequently disposes of the equity, however, any appreciation occurring after the date the equity was vested will be treated as “capital gain” for federal income tax purposes. As of the date of this article, the highest ordinary income tax rate is 35%, while the typical long-term capital gains tax rate is 15%.

This rate differential gives rise to a unique tax planning opportunity commonly known as a “Section 83(b) election”(named after the section of the federal tax code within which it is found). As discussed above, employees will generally not recognize a tax liability until their equity is vested. If an employee makes a Section 83(b) election, however, ordinary income is accelerated and the employee voluntarily pays tax presently as if he or she earned the full amount of equity as of the date of the election. This essentially cuts-off any further ordinary income tax liability and allows future gains to be treated as capital gains. Thus, if the employee anticipates that the company will quickly appreciate in value, the employee will want to recognize any income tax liability as soon as possible in order to convert any future appreciation into capital gain as opposed to ordinary income. If exercised, the Section 83(b) election creates risk that the equity does not appreciate, in which case the person who exercised the election will have paid taxes sooner than would have otherwise been required. Further, if the person leaves the employ of the company before vesting occurs, the payment of taxes under Section83(b) will prove to have been unnecessary altogether.

Finally, if an employee receives an equity appreciation award, the employee will generally not realize any immediate tax liability but will realize ordinary income when the award is actually paid.

While a vesting schedule will generally allow an employee to defer tax liability until the equity is vested, it will also delay the employer’s ability to deduct that amount as compensation paid. Conversely, a Section 83(b) election causes an acceleration of both the employee’s payment of taxes and the employer’s deduction of the compensation expense. While the timing of the employer’s tax deduction is generally not a predominant factor in structuring equity incentive plans (instead, the employee’s tax considerations are typically a driving force), it is a factor that should nonetheless be considered.

Not only will a vesting schedule allow employees to defer tax liability until the equity is vested, such provisions also entice employees to continue their employment with the employer. The employer can use a vesting schedule to condition vesting upon on any number of factors, including certain performance criteria or simply the continued employment with the employer. If the employee fails to meet the specified performance criteria or terminates his or her employment, the employee’s “non-vested” equity will be forfeited. This is known as a golden handcuff provision because the employee is essentially “handcuffed” to the employer until the vesting provisions expire and the employee can reap the economic benefits of the equity grant.

Finally, prior to forming an equity incentive plan, an employer would typically want to have a buy/sell agreement in place which provides for the redemption of the employee’s equity once the employee/employer relationship is terminated. For example, once an employee is terminated for poor performance, the employer would probably not want that employee to maintain his or her equity interest in the company. Redemption provisions allowing for the employer to redeem all shares held by a departing employee are typically found in a buy/sell agreement, sometimes known as a shareholders agreement, operating agreement or limited partnership agreement, depending on the type of entity involved. A condition precedent to an equity or option grant should be that the employee execute whatever form of buy/sell agreement is in place prior to receiving equity. This will ensure that the employee can be divested of his or her equity upon terminating his or her relationship with the company. Further, it could allow the employee to cash-in on the grant at some predetermined future date(for example, upon retirement), by requiring the company to redeem the employee’s equity for a fixed (or formulaic) price.

Equity incentive plans and buy/sell agreements can be structured in any number of ways in order to achieve the employer’s and the employee’s objectives. Careful planning must be undertaken in order to avoid adverse tax consequences and to ensure that any favorable tax treatment that is available is achieved, while simultaneously using these plans to attract, retain and motivate the best and brightest.