July 2014

As youve probably noticed, personal tax rates have gone up in the last several years, now topping out at 39.6 percent on ordinary income for those in the top tax bracket. Add to that increased capital gains rates and the new 3.8 percent net investment income tax, and you may feel like theres not much income left. At the same time, some companies are turning to stock options and restricted stock units (RSUs) as a way of compensating and incentivizing their employees. For those whove been granted these incentives, its more important than ever to understand how your compensation plan is taxed and what you can do to reduce your exposure.

You cant make the taxes associated with your stock options go away entirely, but there are some strategies you can use to temper them. These strategies vary based on the type of grant youve received and, of course, your personal tax situation.

Types of Stock and Associated Taxes

In general, there are four federal taxes that impact employee stock grants:

• Ordinary income tax is charged on your basic (earned) income, including wages, consulting fees, interest income, ordinary dividends, and net rental income. The rate can range from 10 to 39.6 percent, depending on your tax bracket.
• Capital gains tax is charged on the sale of capital assetsthat is, stock held in private or public companies. If you hold the stock for longer than a year, the sale will be subject to the preferential long-term capital gains treatment20 percent at the top tax bracket. Hold the stock for less than a year, and its considered a short-term gain and subject to your ordinary tax rateup to 39.6 percent.
• Alternative minimum tax (AMT) is calculated starting with a series of modifications to your taxable incomeincluding adding back deductions (such as for state tax) and incorporating spread income from the exercise of incentive stock options (ISOs). The effect on taxpayers with ISOs is a higher taxable income than theyd usually be taxed on, which is then subject to the 28 percent AMT (though it will normally generate a tax credit carryforward). Each year youre required to pay whichever amount is higher: your regular tax or your AMTso exercising ISOs can create a tax liability even if you havent received any income. For this reason, the AMT is often called a phantom tax.
• Net investment income tax is an additional 3.8 percent tax on passive income, including investment income, for taxpayers with income above certain thresholds ($200,000 for a single taxpayer in 2014). See our earlier Insight for more on this tax.

State and local taxes will, of course, also play a role in your tax strategy. Most methods of reducing your tax exposure involve reducing how much of your stock income is subject to ordinary income tax and making it subject to the long-term capital gains treatment insteada potential tax improvement of nearly 20 percent. Taxpayers will need to remain wary, however, of the AMT, since exercising ISOs could have you paying more in AMT than you would in ordinary income tax, even at 39.6 percent. (Remember that each year youre required to pay whichever of the two amounts is greater).

Common types of employee stock grants include:

Next well look at a few ways you may be able to reduce the tax impact of your stock options and RSUs.

Exercise Early-Stage ISOs Before Their Value Increases

One tax strategy for taxpayers with ISOs is to exercise the stock options quickly, before theres a spread in the grant price and the fair market value. On the one hand, youll be out the cash for the purchase of the options at a time when you cant sell them yet (assuming your options are for a nonliquid stock). On the other hand, because there is no spread, you wont need to be concerned about driving up your taxable income for purposes of the AMT calculation.

Though this is a simple strategy, many investors dont act quickly enough to implement it. Its especially useful if your ISOs represent less than 10 percent of your net worth and therefore arent particularly risky to youor if the shares are truly inexpensive (pennies apiece). And by exercising your ISOs as soon as possible, you get the capital gains clock rolling, so youll sooner be able to sell at the preferential long-term capital gains tax rate.

Make the 83(b) Election for Early Exercise

Almost all stock option grants come with vesting restrictionsan amount of time that must elapse before you can take ownership of the stock. But many companies also offer the right to early exercise. By electing early exercise, you accelerate the income tax consequences of exercising your stock, paying tax at the time of exercise rather than at vesting. As in the previous strategy, this starts the capital gains holding clock right awaybut in this case, its before your stock options have even vested.

To pursue this strategy, youll need to file the Internal Revenue Code Section 83(b) election form within 30 days of purchasing your unvested options. Any spread between your exercise price and the value of the common stock will become taxable income at the time you file your election. Note that this strategy cant be applied to RSUs.

Exercise ISOs to AMT Crossover Point

As you know, each year you pay the greater of your AMT or your ordinary tax rate. Many taxpayers ordinary tax rate is higher than their AMT in any given year, so in this strategy (assuming you havent exercised any ISOs already) youd exercise ISOs only up to the point where you would enter AMT. This is referred to as the AMT crossover point the point at which youd begin to pay AMT on any additional ISO exercises. By purchasing stock only up to the crossover point, youre essentially exercising them tax-free. But exercise any more, and youll end up paying the AMT phantom tax.

Raise Your Ordinary Income with Same-Day Sales

If youre already in AMT and your stock is freely tradable, you may want to consider pursuing a same-day sale strategy. By exercising your options and then selling the stock immediately, youll raise your ordinary income such that your ordinary tax liability surpasses your AMT. Once youre out of AMT (and depending on how much additional leeway youve created for yourself) you could go back and exercise more ISOs back up to the crossover point.

Exercise ISOs Early in the Year

Not holding your ISOs long enough can trigger a disqualifying disposition that makes your gains taxable as ordinary incomebut you can use this feature to your advantage. When you exercise an option, then sell it later in the year (triggering the disqualifying disposition), your income is computed by measuring the spread on the day of exercise; then a short-term capital gain or loss is incurred (in the same year). You dont have to pick up the AMT income from the day of exercise, because its been disqualified before year-end.

If your ISO is for a publicly traded stock, exercise early in the year and wait to see whether the stock price goes up or down by the end of the year. If its gone down, you sell: This triggers the disqualifying disposition and frees you from paying AMT on the spread when you exercised (which would be higher than the present spread). If the stock goes up, you continue to hold it, aiming for the long-term capital gains treatment.

To illustrate, say you exercise a portion of your ISOs on January 5. Your grant price is $1 per share, and the fair market value is $51 at the time you exercise. In the third quarter the company underperforms, and stock trades down to $31 a share. If youre in AMT and you dont sell the stock, youll pay the 28 percent AMT on a $50 spread despite the fact that the stock is now worth much less, generating a $14 tax liability. If you sell the stock instead, triggering the disqualifying disposition, youve generated $30 in ordinary income with a corresponding tax liability (assuming youre still in AMT) of only $8.40. Depending on how many ISOs youve exercised, the tax savings could add up quickly.

Take Deductions in Years with High RSU Vesting Income

Unlike the other employee stock grant types weve discussed, RSUs become taxable as ordinary income when they vest; theyre then freely tradable so long as you arent subject to insider lockup rules. The income from their vesting is reported on your pay stub, and the associated income and payroll taxes are automatically withheld. Regardless of whether you hold them or sell them, youve already paid income tax on the vesting of those shares. That part of RSUs is out of your controlbut you can still reduce your overall tax bill with a little planning.

In years when large blocks of RSUs vest, your ordinary income tax will usually exceed your AMT due to the additional ordinary income. As long as thats the caseyoure not in AMTyou can use state income tax and property tax deductions to reduce your ordinary income tax liability. If youre likely to be in AMT next year (say, because youll have fewer RSUs vesting), you wont benefit from any state income tax or property tax deductions taken then. You could wait to pay your state taxes until you file your return next Aprilbut if you pay them by December 31, youll be able to deduct them from the current years taxable income, which means a reduction in your tax liability you wont be able to take if you wait.

Were Here to Help

Whether these strategies will be effective ways to reduce the tax impact of your stock options or RSUs will depend largely on your particular compensation package and your personal tax situation. To learn if one of these strategies or others may work for you and for help applying it effectively, contact your Moss Adams tax professional.

Toby Johnston, CPA, CFP, has been providing tax and financial planning solutions to clients since 2001. He helps business owners, executives and families with stock option planning, income tax planning, estate planning, and charitable giving. You can reach him at (408) 369-2470 or toby.johnston@mossadams.com .

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