Cashless Exercise of ISOs

Considerations when you sell ISO shares at the same time you exercise the option.

Some employers make it easier for option holders to exercise their incentive stock options by providing a method of "cashless exercise." Usually the company makes arrangements with a brokerage firm, which loans the money needed to buy the stock. The brokerage firm sells some or all of the stock immediately, with part of the proceeds being used to repay the loan — often on the same day the loan was made. The remaining proceeds (net of any withholding and brokerage commissions or other fees) are paid to the option holder.

Not all companies permit this method of exercise. Some companies want to encourage option holders to retain the stock so they'll have an ongoing stake in the business. Others may be concerned that sales executed in this manner will depress the price of their stock. Review your option documents, or check with the company, to see if this method is available.

Tax consequences

A cashless exercise doesn't necessarily involve the sale of all shares you acquire. As to any shares you retain in the transaction, your tax consequences are as described in Exercise of ISOs.

As to shares you sell at the time of exercise, the tax consequences are essentially the same as for the exercise of a nonqualified option. You're required to report compensation income (not capital gain) equal to the bargain element in the exercise of the option. You should not report an AMT adjustment for these shares. In addition, you'll report  the sale of the shares on Schedule D. Normally you won't have any loss to report because the amount of income you report is limited to the actual gain on the sale when the sale occurs in the same year you exercised the option. You could have to report a gain (usually only a small one) if the sale is at a price higher than the value used to determine your income from exercising the option.

There's one way the ISO may give different treatment from the nonqualified stock option, even when you sell the shares immediately. You don't pay employment tax (social security tax) and your employer isn't required to withhold when you make a "disqualifying disposition" of ISO stock. Make sure you set aside enough money from the sale proceeds to pay the income tax on the compensation income!