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Tax rules that apply when you use stock to exercise nonqualified stock options.
Some companies permit option holders to use shares of stock they already own (rather than cash) to pay the purchase price when they exercise a nonqualified stock option to buy new shares. You get credit for current value on the old shares you turn in, which is higher than the option price for the new shares you receive in the exchange.
Example: You have an option to buy 600 shares of stock for $5 per share. The current value of the stock is $12 per share. To exercise the option you can pay $3,000 in cash — or, if your company permits, you can "pay" $3,000 in stock. You would turn in 250 shares (250 times the current value of $12 equals $3,000) and receive 600 shares (an increase of 350 shares).
This form of exercise is often very convenient because it relieves the option holder of the need to come up with cash to exercise the option. (Cash will still be required to cover tax withholding and other tax liabilities, however.) What's more, the tax results may be favorable when compared to an alternative where you sell stock to come up with the cash to exercise your option.
Not all companies permit this form of exercise. The company may not like this approach because it puts fewer shares in the hands of its key employees compared to a cash exercise. Possibly the company (or its shareholders) believe that a cash exercise shows greater commitment or has greater integrity. Whatever the reason, you can't assume this method of exercise is available. Read your option agreement and the stock option plan under which it was issued, and ask the appropriate person at your company if you're still unsure.
Of course this method of exercise isn't available if you don't own stock in the company. You'll need to use cash, at least for your first purchase. After that you may be able to use stock you bought from an earlier exercise of an option to exercise later options.
Note: The rules described below don't apply to incentive stock options.
The tax consequences when you use stock to exercise a nonqualified option are unique. You're treated as if two separate things happened:
As to the exchange shares you don't report any income. The shares you receive in the exchange have the same basis and holding period as the shares you turned in. It's as if you simply continued to hold the old shares.
As to the new shares, you have to report the value as compensation income, the same as if you had received a Grant or Award of Stock. Those shares take a basis equal to the amount of compensation income you report, and your holding period begins when you acquire them.
In the example above, you would end up with 250 shares that have the same basis and holding period as the shares you turned in, plus 350 shares with a basis of $12 per share and a holding period that begins when you acquire the shares.
When you decide to sell some of your shares, it will be important to determine which shares you want to sell. In some cases you'll be better off selling the older shares because they qualify for long-term capital gain treatment. In other cases you'll want to sell the newer shares because they have a higher basis. For an explanation of how to identify the shares you're selling, see Identifying the Shares You Sell.
It may be possible to use shares from a previous exercise of an incentive stock option to pay the purchase price on exercise of a nonqualified stock option. This exchange will not be treated as a disposition of the ISO stock. In the example above, if you turned in 250 ISO shares, then 250 of the shares you received in the exchange would be treated as ISO shares with the same basis and holding period as the shares you turned in. If the shares you turned in were "immature ISO shares" then the shares received in the exchange are also "immature ISO shares." See Early Disposition of ISO Stock.
A different rule applies if you use ISO shares to exercise an ISO!
This method of exercising an option doesn't produce any magical tax benefits. The greatest advantage is in situations where you would have to sell stock you already own in order to come up with the money you need to exercise the option. In this case, using stock to exercise the option permits you to avoid reporting gain from a sale of those shares. But you'll report the gain eventually, so this is a tax deferral, not a tax reduction.
If one of the alternatives available to you is a Cashless Exercise of your option, you should find that the method described on this page has almost exactly the same consequences. In a cashless exercise you borrow to exercise the option and immediately sell some of the shares to pay off the loan. Normally the sale produces very little gain or loss, and you end up holding the same number of shares (and reporting the same amount of income) as if you had used stock to exercise your option.
There's another alternative in many cases: using cash from some other source to exercise the option. If you do this your holdings in that stock will increase more than if you chose a cashless exercise or used stock to exercise the option. The issue here is an investment question, not a tax question: do you want to maximize your holdings in the company's stock? If so, use cash from another source to exercise your option. If not, consider a cashless exercise or using stock to exercise, assuming those alternatives are available.
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