ISO Exercise Using Stock

Some companies permit option holders to use shares of stock they already own (rather than cash) to pay the purchase price when they exercise an incentive 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 incentive stock 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).

Preliminaries

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 liabilities, however.) 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.

Availability

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.

Tax authorities

The tax consequences described below are based in large part on proposed regulations and private letter rulings. These authorities aren’t binding on the IRS, so it’s possible in theory that the IRS could challenge a return filed on the basis of these rules. As a practical matter that’s very unlikely because the IRS position on these matters hasn’t changed in many years.

Source of the old stock

The tax consequences of this form of exercise depend on whether or not you use immature ISO stock to exercise the option. You have immature ISO stock if you acquired the stock by exercising an incentive stock option and haven’t yet satisfied the special ISO holding period. See Early Disposition of ISO Stock.

If you’re not using immature ISO stock to pay for the shares you’re buying, the shares you’re using can be any of the following:

• Mature ISO stock (in other words, stock you acquired by exercising an incentive stock option long enough ago so that you’ve met the special ISO holding period).
• Stock from exercising nonqualified stock options.
• Stock acquired in any other way, including purchases on the open market.

Using shares other than immature ISO shares

This section lays out the tax consequences when you use shares other than immature ISO stock to pay the purchase price to exercise an incentive stock option.

Regular income tax consequences

First we’ll look at the regular income tax consequences when you use stock (other than immature ISO stock) to exercise an incentive stock option:

• For regular tax purposes, you don’t report any income on the exercise of the incentive stock option. (This rule is the same as if you used cash to exercise your option.)
• You don’t report any gain or loss on the shares you used to pay the purchase price on the option. That’s because you’re considered to have made a tax-free exchange of those shares for ISO shares.
• The shares you receive are divided into two groups. One group includes a number of shares equal to the number of shares you turned in (the exchange shares). The other group includes all the additional shares you received (the added shares).
• The exchange shares have the same basis as the shares you turned in. They also have the same holding period as the shares you turned in — but only for purposes of determining whether any capital gain or loss on a sale is long-term. For purposes of determining whether you’ve satisfied the special ISO holding period, your holding period for these shares begins on the date you exercise the option.
• The added shares have a basis equal to the amount of cash you paid to exercise the option (which may be zero, or close to zero). These shares have a holding period that begins on the date you exercised the option.
• Both the exchange shares and the added shares are subject to the rules that can cause you to report compensation income if you make an early disposition (also known as a disqualifying disposition) before satisfying the special ISO holding period. The proposed regulations state that you are deemed to have sold the shares with the lowest basis first if you sell only some of the shares. It’s questionable whether the IRS can enforce this rule because proposed regulations aren’t binding on taxpayers, and other authorities indicate that a taxpayer can choose to dispose of the higher basis shares first.

AMT consequences

The IRS hasn’t spelled out the consequences under the alternative minimum tax in as great detail as the regular tax consequences. The following results would be consistent with the approach the IRS has taken in this area:

• You have to report an AMT adjustment in the same amount as if you had used cash to exercise the option (see Exercising Incentive Stock Options).
• The exchange shares have the same AMT basis as the shares you used to pay the exercise price.
• The added shares have an AMT basis equal to the amount of cash you paid plus the amount of the AMT adjustment.

Using immature ISO shares

This section lays out the tax consequences when you use immature ISO stock to pay the purchase price when you exercise an incentive stock option.

Regular income tax consequences

Here are the regular income tax consequences when you use immature ISO stock to exercise an incentive stock option:

• For regular income tax purposes, you don’t report any income on the exercise of the new ISO.
• However, you’ve made a disqualifying disposition of the immature ISO stock you turned in. That means you have to report compensation income equal to the bargain element from the exercise of the old ISO, in which you acquired the immature ISO stock. You can’t reduce the amount you report as compensation income even if the stock has declined in value since the date of the previous option exercise.
• At the same time, the disposition of the immature ISO stock is treated in part as a tax-free exchange. So apart from the compensation income you report as described above, you don’t report gain or loss on the exchange of old ISO shares for new ISO shares, even if the stock has gone up in value since the previous option exercise.
• The shares you receive are divided into two groups. One group includes a number of shares equal to the number of shares you turned in (the exchange shares). The other group includes all the additional shares you received (the added shares).
• The exchange shares have the same basis as the shares you turned in, increased by the amount of compensation income reported because of the disqualifying disposition. They also have the same holding period as the shares you turned in — but only for purposes of determining whether any capital gain or loss on a sale is long-term. For purposes of determining whether you’ve satisfied the special ISO holding period, your holding period for these shares begins on the date you exercise the new ISO.
• The added shares have a basis equal to the amount of cash you paid to exercise the option (which may be zero, or close to zero). These shares have a holding period that begins on the date you exercised the new ISO.
• Both the exchange shares and the added shares are subject to the rules that can cause you to report compensation income if you make an early disposition of ISO stock before satisfying the special ISO holding period. The proposed regulations state that you are deemed to have sold the shares with the lowest basis first if you sell only some of the shares. It’s questionable whether the IRS can enforce this rule because proposed regulations aren’t binding on taxpayers, and other authorities indicate that a taxpayer can choose to dispose of the higher basis shares first.

AMT consequences

The following description of alternative minimum tax consequences would be consistent with the approach the IRS has taken in this area:

• You have to report an AMT adjustment on the exercise of the new ISO in the same amount as if you had used cash to exercise the option (see Exercising Incentive Stock Options).
• The exchange shares have the same AMT basis as the shares you used to pay the exercise price.
• The added shares have an AMT basis equal to the amount of cash you paid plus the amount of the AMT adjustment.