When Shares Lose Value
After exercising an option
By Kaye A. Thomas
Posted March 3, 2009
Can you avoid the tax consequences of exercising an option?
Someone posted this question on our message board:
Say that I exercised an ISO option for $.10 and the fair market value at the time of exercise is $1. What happens if the market value falls somewhere close to zero after I exercised the option? The company is private so there's no market to sell these shares. Am I taxed at the market value at the time of exercise? Is there a way to avoid paying the tax, or get back taxes paid on something that is now worth little or nothing?
Here's a review of possible ways to recover from a loss of stock value after exercising an option, including some that may not apply in this particular situation.
Vesting
The first thing to consider is whether the shares were vested at the time you exercised the option. If vesting occurred later, after the decline in value, the tax consequences of exercising the option may be reduced or eliminated.
In practice this question rarely provides relief. When a company is publicly traded, it's nearly always the case that shares are vested at the time an option is exercised, even if there is a temporary restriction on selling the shares. Private companies sometimes set up option plans that allow people to exercise options before the shares are vested, but in this case optionees are usually advised to file the section 83b election at the time they exercise the option. Filing the 83b election causes the stock to be treated as vested, and you can't retract this election except within the first 30 days after exercising the option (the same period in which you're allowed to make the election). The mere fact that there is no market for your shares doesn't mean they aren't vested.
Generally speaking, you'll get relief here only if there was a mistake of some kind: someone thought the stock was vested when it wasn't, or someone failed to file the 83b election when it was supposed to be filed.
Rescission
Apart from finding that you lucked into a situation where your shares vested after the decline in value, rescission is the only form of relief that works for both incentive stock options (ISOs) and nonqualified stock options. You and the company have to agree to undo the exercise of the option. In a true rescission, everything goes back to the situation that would exist if you never exercised the option. That means you give the stock back to the company, and they return to you the money or other consideration you paid to exercise the option. In addition, your rights under the option are restored to what they would be if you hadn't exercised it. IRS ruling practice indicates they will treat you as if you never exercised the option following a rescission, but only if rescission occurs in the same year you exercised the option.
Rescission requires the cooperation of the company, including a willingness to return to you the option price after the shares declined in value, something the company may be understandably unwilling to do. Generally easier remedies are available when dealing with ISOs, so rescission is generally seen only after a steep decline in stock value occurs within the same year a nonqualified stock option has been exercised.
Sale of ISO stock
If you sell ISO stock within the same year you exercised the option, your taxable income from the option exercise is limited, for both regular income tax and alternative minimum tax (AMT), to the amount of profit you netted. You have to sell the shares to an unrelated person (don't donate them to charity or use them to make a gift) and avoid buying replacement shares in the same company within the 61-day wash sale period (date of sale plus 30 days before and after). In a private company there isn't a market for the shares but it may be possible to sell the shares in a private transaction, perhaps to someone else who works at the company or to one of the company's principal investors. As in the case of rescission, this action has to occur in the same year you exercised the option, because your AMT consequences are locked in as of December 31.
Abandonment
You may find it is simply impossible to sell your ISO stock. In that situation, it appears that you can avoid the tax consequences of exercising an ISO if you abandon the shares by the end of the year of exercise. Abandonment involves giving up all rights you have to the shares — and that includes the right to determine who will benefit if the stock ever recovers, so a gift or donation of the shares does not count as abandonment. Regulations say that abandonment is considered an event that establishes the worthlessness of shares in the year of the abandonment, and that means you're treated as selling the shares for $0 on the last day of the year. That should be good enough to get you out of any AMT consequences for exercising an ISO if the abandonment occurs in the year of exercise. I'm not aware of any direct authority on this issue, so it's possible the IRS would take a different view, but I can't think of any reason they would object to this treatment.
Worthlessness
Even without abandonment it may be possible to establish that the shares became worthless in the year you exercised the ISO. The logic here is the same as for abandonment: when shares become worthless, you're treated as having sold them for $0 on the last day of the year. It's rarely possible to demonstrate that shares truly became completely worthless such a short time after the exercise of a stock option, however, particularly if the company remains in operation.
Value at exercise
If you can't obtain relief under any of the alternatives above, your last hope for mitigating the tax cost in the year of exercise may be to establish that the shares really didn't have the value they were thought to have at the time you exercised the option. With the benefit of hindsight it may seem obvious that the shares weren't really worth that much, but subsequent events can't be used to show a lower value. Disputing the date-of-exercise value can raise a number of uncomfortable issues and is rarely a fruitful approach, but a desperate situation may call for desperate measures.
Recovering the tax
Assuming you're stuck with the tax in the year of exercise, you'll want to recover whatever you can in a later year when you dispose of the shares or establish their worthlessness. Chances are you won't like the results.
For nonqualified stock options, you're treated like someone who bought shares for an amount equal to the exercise price, increased by the amount of income reported on the exercise of the option (or on the subsequent vesting of the shares). If you sell these shares at a lower price, or they become worthless, or you abandon them, you'll have a capital loss, subject to the $3,000 per year capital loss limitation. You can have a situation where you reported $500,000 as income on exercise of the option but can claim only $3,000 of loss when the shares become worthless the next year. That's what we call a capital loss whipsaw, and it's the hardest of hard luck: the tax law provides no relief.
For ISOs your situation may be better because of the possibility of recovering some or all of the AMT you pay in the year of exercise as AMT credit in a later year. Yet a capital loss whipsaw can occur under the AMT as well, preventing you from recovering more than a small fraction of the tax paid in the year of exercise. This is essentially what happened to many people who exercised ISOs before the tech stock collapse that began early in the year 2000. Congress has changed the law to allow those people (and many who exercised ISOs later) to recover previously paid AMT, but the provision clicks in only when your credit remains unrecovered at least four years, and is set to expire after 2012. If you can't recover the full amount by then, you may be left with a large unused, and largely unusable, AMT credit carryover.
