taxation after a corporate acquisition event: unexercised but vested stock options

Consider the following scenario:
1. Company A buys company B. 2. Employees of B hold some vested, but un-exercised incentive stock options (ISO). 3. As part of the buyout process, these options get exercised and
paid in cash by A.
My question is, should the cash paid be treated as a short term capital gain or as regular income?
========================================= MODERATOR'S COMMENT: Ordinary income treatment, flowing to a W-2 form.
--
<< ------------------------------------------------------- >>
<< The foregoing was not intended or written to be used, >>
  Click to see the full signature.
Add pictures here
<% if( /^image/.test(type) ){ %>
<% } %>
<%-name%>
Add image file
Upload
snipped-for-privacy@gmail.com wrote:

As the options are being exercised and sold on the same day, the statutory holding period for favorable treatment has not been met. As such, this is a disqualifying disposition. The difference between market value and the exercise price is all compensation (ordinary income). As the moderator said.. it should be reflected on a W-2. Even if it is not on a W-2, the gain gets entered on Line 7 of the tax form.
From a technical point of view... your ordinary gain gets added to what you paid to arrive at an adjusted cost basis. The difference between the sales proceeds and this adjusted basis is your short term capital gain or loss. This can actually happen if there are commissions and or fees paid as part of the transaction and market value and sales proceeds are not equal.
--
<< ------------------------------------------------------- >>
<< The foregoing was not intended or written to be used, >>
  Click to see the full signature.
Add pictures here
<% if( /^image/.test(type) ){ %>
<% } %>
<%-name%>
Add image file
Upload
On Feb 9, 9:44pm, snipped-for-privacy@gmail.com wrote:

I am suspicious of the description of the circumstances. Consequently, I would be wary of responders' interpretation and their answers.
At issue is the statement that options "get exercised and paid in cash by A" in Step 3.
Do you mean that you were give the choice to exercise those options, which you did? For an option to be exercised, __you__ must pay the exercise price. Of course, there is no way that the company can force that to happen "as part of the buyout process".
In that case, it is a normal disqualifying disposition, as some responders have said.
Or do you really mean that the company paid you some amount of cash (either the exercise price or the FMV) for the options that your held?
In that case, this is an exchange, not an exercise. But because it is an exchange for employee compensation (the employee stock option), I believe the entire cash amount received should be treated as compensation (i.e. wage income).
In either case, your company should be the best source of information for how to treat this transaction. Although the company might assert that they cannot give "tax advice", it is standard practice (if not a legal requirement) for them to provide "tax information" -- that is, general information about the tax consequences.
Since this regards an employee situation, contact personnel, not investor services. In fact, the latter is likely to give you the wrong information -- information about open-market stock options, not employee stock options, which are treated very differently, as you may know.
--
<< ------------------------------------------------------- >>
<< The foregoing was not intended or written to be used, >>
  Click to see the full signature.
Add pictures here
<% if( /^image/.test(type) ){ %>
<% } %>
<%-name%>
Add image file
Upload
Everybody: thanks for the replies, this was very helpful.
Moderator, thanks for the reply.
Joeu2004 brought up an interesting point: The employees were not offered explicitly to exercise (and then sell) the options per se. In fact, the transaction may very well have been structured as an "exchange" of the option for its FMV, which was the takeover share price minus the option original price.It sounds like this would (probably) mean the proceeds are treated as ordinary income.
But what if the transaction was indeed structured as an "exercise-then- sell". Does that make a difference? Would the company have a (self- interest, tax) reason NOT to structure the transaction as a two-step process, since this would enable employees to qualify for 28% STCG tax versus up to 35% ordinary income tax? Why would the company not try to make the employees happier by doing that?
Alan, I was not angling for the 15% LTCG "favorable treatment", if that is what you meant. Only the favorable treatment of 28% STCG tax versus ordinary income tax.
--
<< ------------------------------------------------------- >>
<< The foregoing was not intended or written to be used, >>
  Click to see the full signature.
Add pictures here
<% if( /^image/.test(type) ){ %>
<% } %>
<%-name%>
Add image file
Upload
On Feb 10, 9:41pm, snipped-for-privacy@gmail.com wrote:

The key point is: the __entire__ amount received would be ordinary income, not the difference between the FMV and the exercise price.

Yes. As both Alan and I stated, that is the disqualifying disposition scenario. The ordinary income would be the difference between the FMV and the exercise price.

Sure: to facilitate and simplify the acquisition process. As I explained previously, only you could exercise the stock option. Moreover, the company cannot force you to exercise the stock option. Either it would have to present you with a "use it or lose it" choice, or it could offer some other alternative of value.
In any case, the company loses some control over the timeline for completing the acquisition process.

Not so. The only difference is the amount of ordinary income that would be taxable. With a cashless exercise, you would receive less, so less than would be taxable <wink>.

I question whether it would make employees happier. I suspect that the exchange for cash resulted in more after-tax income. Do the math and see for yourself.
--
<< ------------------------------------------------------- >>
<< The foregoing was not intended or written to be used, >>
  Click to see the full signature.
Add pictures here
<% if( /^image/.test(type) ){ %>
<% } %>
<%-name%>
Add image file
Upload

Joeu2004,
I just realized that I left out some details that are important, namely:
Company A = public Company B = private All-cash transaction
Hence, when I talk about "exercise-then-sell" this is all a private transaction at a pre-set share price, for cash. Company A stock is never involved, The exercise would be for Company B stock, which in turn would be bought by Company A for cash, at the predetermined share price.
Does that make a difference to the analysis? With the additional constraints, can you see a way that a two-step exercise+sell disposition of the vested options could be structured so as to qualify for STCG?
--
<< ------------------------------------------------------- >>
<< The foregoing was not intended or written to be used, >>
  Click to see the full signature.
Add pictures here
<% if( /^image/.test(type) ){ %>
<% } %>
<%-name%>
Add image file
Upload
On Feb 12, 7:33am, snipped-for-privacy@gmail.com wrote:

And let's not forget the fact that all this -- exercise of ISOs and subsequent sale (by you to Company A) -- occurs within 12 months of the exercise. Right?

Not really. Since you are selling ISOs within 12 months of the exercise, the difference between the selling price (the amount Company A pays) and the exercise price (what paid Company B when you exercised the ISO) is treated as ordinary income, specifically wage income. That's all there is to it.

If you paid commission and SEC fees to a broker for the transactions, the commission and fees would effectively be a short-term capital loss. But I have never heard of brokerage fees being paid by the employee in this kind of transaction resulting from a merger or acquisition.
We seem to be beating a dead horse.
--
<< ------------------------------------------------------- >>
<< The foregoing was not intended or written to be used, >>
  Click to see the full signature.
Add pictures here
<% if( /^image/.test(type) ){ %>
<% } %>
<%-name%>
Add image file
Upload

Ok. I think I get the point, although I had difficulty understanding it earlier, amid the other technicalities.
For ISOs, taxation is either
1.. regular income or 2. long term capital gains (LTCG)
There is no middle ground (that is, Short Term Capital Gain treatment just is not possible, no way, no how).
Right or wrong? (and I'll stop beating the horse)
--
<< ------------------------------------------------------- >>
<< The foregoing was not intended or written to be used, >>
  Click to see the full signature.
Add pictures here
<% if( /^image/.test(type) ){ %>
<% } %>
<%-name%>
Add image file
Upload
On Feb 12, 9:06pm, snipped-for-privacy@gmail.com wrote:

Essentially right, for my interpretation of the facts as you have presented them. Here is the complete picture. Hope it does not obfuscate things.
For ISOs held at least 1 year and a day after exercise __and__ 2 years and a day after grant, all of the difference between the exercise price and selling price (less commision and fees) is treated as long-term gain (loss).
Otherwise, if either of the above conditions is not met:
a. The difference between exercise price and fair market value (FMV) on the exercise date is treated as compensation and taxed at the ordinary income tax rate.
Exception: If the FMV is less than the exercise price, the compensation is zero; ergo, there is no ordinary income tax.
b. The difference between the FMV (now the basis of the stock) and the selling price (less commission and fees) is treated as short-term capital gain (loss).
Note that in the exception case in #a, all of the difference between FMV and selling price (less commission and fees) would be treated as short-term capital gain (loss).
At issue is the determination of the FMV.
Normally, the FMV on the exercise date is determined by the company, within certain flexible guidelines set by regulations.
For publicly-trade stock, typically the FMV is either the closing price or the average of the high and low prices for the day (or "recent" time frame).
But in the case of an exercise and sale on the same day, it has become common practice (if not dictated by regulation) to use the selling price as the FMV. That is why in #b above, there is negligible short-term gain (loss), namely only the commission and fees, if any. (Probably none in your case.)
If the sale is on a different day, for privately-held stock (presumably not traded frequently), the FMV on the exercise date is determined by a "recent" sale (within a regulated time frame) or by a complex valuation of the company. In my opinion, in your case, the FMV would be set by the price that Company A is willing to pay for the Company B stock; thus, I believe the FMV is the selling price. So once again, #b would result in negligible short-term gain (loss), and probably none.
Hope that helps and disposes of all your questions.
--
<< ------------------------------------------------------- >>
<< The foregoing was not intended or written to be used, >>
  Click to see the full signature.
Add pictures here
<% if( /^image/.test(type) ){ %>
<% } %>
<%-name%>
Add image file
Upload

It does, thank you. If I dare summarize:
The implied gain (FMV-EV), if any, of an OPTION EXERCISE is always recognized immediately as regular income. Any further gain (or losses) on shares subsequently held are long-or-short term capital gains, depending on the holding period.
Likewise, any gain on an OPTION SALE/EXCHANGE is regular income. (does that apply to all kinds of options, including publi
Special case:
If one exercises options while share price == exercise price, the implied gain is 0, hence there is no regular income to recognize on the option exercise.
Moreover (care to correct this if I got any details wrong?):
If additionally one exercises "early", aka. before vesting, and file a properly worded 83(b) election within 30days, the 1-year clock to achieve LTCG status starts ticking at the time of filing (or the time of the early excercise/delivery?). Additionally, for LTCG treatment, it is required that the option grant itself is at least 2 years old at the time of sale.
Did I screw anything up?
--
<< ------------------------------------------------------- >>
<< The foregoing was not intended or written to be used, >>
  Click to see the full signature.
Add pictures here
<% if( /^image/.test(type) ){ %>
<% } %>
<%-name%>
Add image file
Upload
On Feb 14, 2:09pm, snipped-for-privacy@gmail.com wrote:

No. I think I was quite clear that that is not true in one case for ISOs (which are different from nonqualified employee stock options).

I think I was also quite clear that there is no long-term gain (loss) for ISOs in the case where some of the appreciation over the exercise price is recognized as ordinary income -- namely, the "otherwise" scenario, which I should have reiterated that it is called a "disqualifying disposition".
I don't seem be helping clear things up. I suggest that you read the explanation at http://fairmark.com/execcomp/index.htm .
PS: I neglected to mention the issue with AMT in the case where ISOs are held at least for 1 year and a day after exercise and 2 years and a day after grant. So it is somewhat misleading for me to say there is no ordinary income tax in that case. However, keep in mind that AMT does not apply to everyone.
--
<< ------------------------------------------------------- >>
<< The foregoing was not intended or written to be used, >>
  Click to see the full signature.
Add pictures here
<% if( /^image/.test(type) ){ %>
<% } %>
<%-name%>
Add image file
Upload
Joeu2004,
First, I apologize again for not quite understanding this. I have read the fairmark.com articles, and it did not ease my confusion.
The only way I can understand your answer (and I thank you again for providing it!) is if there is some sort of terminology mismatch between you and I. Please read below.

This I do not get. When I said OPTION EXERCISE, I meant the action of turning the option into stock, with an unrealized gain of FMV-OP(option price). I did not mean to include, in any way, shape or form, the subsequent sale of the stock (yet).
When you said "in one case for ISOs" in the quoted text above, it appears to me that you were talking about the holding period for the stock that you got from the ISO, and not for the ISO itself.
Also, In your longer answer that I was trying to summarize, you used the expression "For ISOs held at least 1 year and a day after exercise". Again, I wouldn't hold ISOs after the exercise, I would hold shares.
The terminology mismatch may be that when I said options exercise, I REALLY meant only the exercise itself.
Now, I somehow, perhaps ignorantly or foolishly, still think that it must be a correct statement that for an option exercise, the gain=FMV-OP is always and immediately recognized as ordinary income. It may be zero, but it is still ordinary income.
Allow me to formulate the scenario in terms of 3 transaction numbered 0-2 as follows:
date0: ISO grant date     , gain0=0 (generally ISO grants are at OP=FMV) date1: ISO exercise into shares, gain1=FMV(date1)-OP date2: Share sale , gain2=FMV(date2)-FMV(date1)
gain0: rarely anything but 0, because startups generally grant ISO options OP=FMV. If gain0>0, treat as ordinary income.
gain1: immediately recognized as ordinary income, can be zero, and this occurs when FMV(date1)<=OP.
gain2: recognized as STCG/LTCG gain/loss, depending on exercise dates, holding periods, 83(b) elections, and whichever other rules may apply. Can be pos, neg or zero. Applies also when date2te1.
The "non-otherwise" section of your original answer corresponds to date0 being 2y+1d ago, date1 being 1y+1d ago, and date0 being today (day of sale).
For the case where date1 involved the direct disposition (exchange) of the options for some other valuable/consideration (cash, other options, what have you), rather than an exercise for shares, the gain1 is again immediately recognized as ordinary income.
How am I doing now? I'm really, really trying to understand the logic behind and the practical consequences of the IRS rules, and the above is the only way I can make sense of it. The basic principles of the IRS seem to be as follows:
1. to recognize (and tax!) gains as early as possible, and always using gain=FMV-CB(cost basis).
2. not to allow speculation (including option transactions) to be treated as capital investments for preferential tax purposes, except for the favorable treatment of ISOs, and the 83(b) election loophole.
If you have given up on this tax amateur by now, I can accept, but I'm honestly trying to understanding the logic and simplify the description as much as possible, all the while making it general enough that ut can be applied to multiple different scenarios that may occur.
--
<< ------------------------------------------------------- >>
<< The foregoing was not intended or written to be used, >>
  Click to see the full signature.
Add pictures here
<% if( /^image/.test(type) ){ %>
<% } %>
<%-name%>
Add image file
Upload
On Feb 15, 2:18pm, snipped-for-privacy@gmail.com wrote:

Yes, I got sloppy with my terms. But what possible meaning could you give to the phrase "hold ISOs ... after exercise"? There are no options per se to hold after you exercise them. Anyway, perhaps I should have said: "hold shares resulting from [or pursant to, in legalese] an ISO ... after exercise".

And that is what I mean, as well. With ISOs (in contrast to nonqualified employee stock options), there is no tax consequence (except perhaps for AMT) when you exercise the option; only when you sell (or otherwise dispose of) the shares resulting from the option exercise.

Yes, that it is a foolish way of looking at it. In any case, you said nothing [*] of allowing for zero "ordinary income" when you wrote originally: "The implied gain (FMV-EV), if any, of an OPTION EXERCISE is always recognized immediately as regular income. Any further gain (or losses) on shares subsequently held are long-or-short term capital gains, depending on the holding period."
By your foolish way of looking at things, there is always both(!) long-term and short-term capital gain; it is just that at least one or the other is zero. (True, but nonsensical!)
[*] The only case you originally spoke of having zero ordinary income was the special case of "share price == exercise price".

I agree that Kaye Thomas's descriptions, while complete, can be overwhelming. I tried to "cut to the chase". Obviously, I am not helping you.
--
<< ------------------------------------------------------- >>
<< The foregoing was not intended or written to be used, >>
  Click to see the full signature.
Add pictures here
<% if( /^image/.test(type) ){ %>
<% } %>
<%-name%>
Add image file
Upload
PS....
On Feb 10, 9:41pm, snipped-for-privacy@gmail.com wrote:

In my previous response, I asserted that the exchange probably resulted in more income for you. But as you describe, it sounds like the exchange had the same or nearly the same effect as if all options had been exercised.

In my previous response, I assumed that you are referring to a cashless exercise; therefore, there would be no (or negligible) STCG (most likely a small loss).
But if by "exercise-then-sell", you are including selling later, then theorerically, yes, there could be a STCG component. But of course, the stock you would be selling later would have to be stock in the Company A.
(And quite frankly, I don't remember whether or not there is a special case in the reorganization statute for exercised, but held ISO shares. No time now to look it up.)

There would indeed be yet-another reason why the company would not want to permit you to exercise, but hold the ISO shares. You would not want it, either.
The exchange rate is based on the number of outstanding shares and FMV of those shares in both companies on the record date. If the company allowed you to exercise and hold ISO shares, the record date would have to be some time after all employees with ISOs announced their intention and exercise their options, if that is their decision. As I said before, the company loses some control over the timeline.
But an employee's decision to exercise and hold v. a cashless exercise would probably depend on the knowing the exchange rate -- that is, the value of their exchanged stock after the acquisition is completed. It's a chicken-and-egg problem.
--
<< ------------------------------------------------------- >>
<< The foregoing was not intended or written to be used, >>
  Click to see the full signature.
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.