Cashless stock option exercise help!

I need a quick stock option refresher course please!
I've got a client with about 11,000 stock options in Southern Co (SO). The grant prices vary, but it will cost him $200,000 to exercise the
options (which he doesn't have in cash). Once purchased, the shares can be redeemed for about $425K. That's a $225K gain before taxes. This is a Non-Qual grant, not an ISO.
This is my understanding. Please correct if necessary. If he does a cashless "exercise and sell" transaction, he will buy and immediately sell all 11,000 shares and the $225K profit will be taxed as ordinary income. But he will have the remaining cash in his pocket.
If he does a cashless "exercise and sell to cover" he will buy all 11,000 shares and only sell enough to pay the $200K it cost him to buy. The $225k gain will be left in stock certs for 13 months and then liquidated. This will cause the $225K gain to be taxed at Capital Gains rates. The downside is that he is subject to the stock volatility for 13 months AND he doesn't have the cash in hand.
We are leaning towards option 2, but I want to make sure I have the taxes correct.
Thanks
Add pictures here
<% if( /^image/.test(type) ){ %>
<% } %>
<%-name%>
Add image file
Upload

Not just ordinary income but (if he's an employee), W-2 wage income, and I believe it'll be subject to SS (to the cap) and Medicare tax.

No, it won't. For an NQO, it is exercise that triggers income, not the subsequent sale.
Since this is a NQO, it goes like this: * Bargain element is taxed as wages *upon exercise*. * Stock basis is exercise price plus recognized wage income.
So for BOTH scenarios, he'll be in the following situation: * $225,000 of wage income * Will receive stock with a basis of $425,000.
In scenario one, he'll have $225,000 of wage income and a minimal short-term capital gain or loss to the extent that what the stock sells for is different than $425,000 (since it's a same-day sale, we'd expect the stock to sell for about the same price that is used by his employer to calculate the recognized wage income).
In scenario two, he'll have $225,000 of wage income and then a long-term capital gain to the extent that what the stock sells for is different than $425,000. Exercise and hold WILL NOT convert the wage income to capital gain.
--
Rich Carreiro snipped-for-privacy@animato.arlington.ma.us


Add pictures here
<% if( /^image/.test(type) ){ %>
<% } %>
<%-name%>
Add image file
Upload
Thanks Rich,
I finally found Pub 525 about 30 seconds after I posted this. Everyone ignore my OP, its completely wrong.
My new understanding is that non-qualified stock options are treated as ordinary income at the time the option is exercised on the difference in market price and grant price (EVEN if the stock is not sold). Basis is then adjusted to current market price for determining gains (either long or short) on the future sale of the stock.
Add pictures here
<% if( /^image/.test(type) ){ %>
<% } %>
<%-name%>
Add image file
Upload
kastnna wrote:

That rule (and the ignorance of such) has indeed caused major financial problems for many silicon valley newly minted paper-rich folks in 2000, when their stock options turned to negative and they ended up owing to the IRS on worthless paper.
Add pictures here
<% if( /^image/.test(type) ){ %>
<% } %>
<%-name%>
Add image file
Upload
PeterL wrote:

Here's one such sobering story. http://preview.tinyurl.com/y93cbg It's about ISOs (Incentive Stock Options) where there is an advantage to exercising and holding as opposed to NQs where there is no such advantage (which is what the OP was asking about). The AMT from exercising ISOs is what affected most people in Silicon Valley. With NQ is there is no advantage to exercising and holding; one might as well just wait to exercise and sell if one really thinks that the stock will keep appreciating.
Anoop
Add pictures here
<% if( /^image/.test(type) ){ %>
<% } %>
<%-name%>
Add image file
Upload
anoop wrote:

In case it's not clear, the issue surrounding the Options is this; Upon exercising, one has a windfall of ordinary income, say $250K to keep the numbers low. Now, if the stock crashed, and many did, you have a capital loss of say $200K. Well, you can only take stock losses to match gains, up to $3000 that you can take off regular income, so in my example, taxes must be paid on $247K, even if the stock is zero. The losses carry forward, $3,000/yr or against other stock gains. I read a story about such a man who found a woman with a $200,000 gain, and got married. (The numbers were higher, more like in the millions, but the story doesn't change). JOE
Add pictures here
<% if( /^image/.test(type) ){ %>
<% } %>
<%-name%>
Add image file
Upload
joetaxpayer wrote:

[...]
Nope, not clear. As anoop wrote, it is the issue with ISO's and AMT that is the nasty one that affected people back in 2000. It generates an AMT deferral item which may or may not ever be recaptured.
The issue you describe is easily avoided by exercising and selling, since there is no incentive to hold the stock, as there is with ISO's. What you are describing is the same as someone getting a $250K cash bonus from their employer and immediately investing it all in one loser stock - why would someone do that on purpose?
-Mark Bole
Add pictures here
<% if( /^image/.test(type) ){ %>
<% } %>
<%-name%>
Add image file
Upload
What Mark said. Exercise and sell that day. The question is simply when to exercise, which depends on the cash needs of the owner and the prospects for the company. AMT can kill you. Don't risk it. Joe Weinstein
Add pictures here
<% if( /^image/.test(type) ){ %>
<% } %>
<%-name%>
Add image file
Upload

The OP is talking about NQOs, so AMT isn't an issue.
--
Rich Carreiro snipped-for-privacy@animato.arlington.ma.us


Add pictures here
<% if( /^image/.test(type) ){ %>
<% } %>
<%-name%>
Add image file
Upload
Rich is right, NQSOs not ISOs.
We did opt to exercise and sell by the way. The employee no longer works for the grantee and the options were set to expire Feb. 1, 2007.
thanks all
Add pictures here
<% if( /^image/.test(type) ){ %>
<% } %>
<%-name%>
Add image file
Upload
Rich Carreiro wrote:

Exactly -- just to clarify some previous replies which were evidently confusing the two.
-Mark Bole
Add pictures here
<% if( /^image/.test(type) ){ %>
<% } %>
<%-name%>
Add image file
Upload

BeanSmart.com is a site by and for consumers of financial services and advice. We are not affiliated with any of the banks, financial services or software manufacturers discussed here. All logos and trade names are the property of their respective owners.

Tax and financial advice you come across on this site is freely given by your peers and professionals on their own time and out of the kindness of their hearts. We can guarantee neither accuracy of such advice nor its applicability for your situation. Simply put, you are fully responsible for the results of using information from this site in real life situations.