ISO Exercise Involving Stock Swap Requires Complex Recordkeeping

Stock options have become an increasingly important and common component of the compensation package for many taxpayers. Previously limited to high-level executives, participation in stock option plans is now often made available to rank-and-file employees. When the options being granted are "qualified" or incentive stock options (ISOs) under Sec. 422, a taxpayer must deal with potential alternative minimum tax (AMT) consequences if he exercises and holds the options. Employers generally communicate this fact to employees in the most basic fashion. The employee recognizes no income for regular tax purposes on exercising an ISO. However, the spread between the stock's fair market value (FMV) on the exercise date and the exercise price, known as the bargain element, is a preference adjustment that could give rise to AMT. The spread also creates a tax basis in the shares acquired that is greater for AMT than for regular tax. At this point, most employees (and certainly most professionals) understand the effect of a straightforward exercise when an employee simply pays cash.

An employer may offer ways to exercise options other than simply paying cash. One of those alternatives is to exchange shares of employer stock that an employee may already hold (stock swap). In a stock swap, the employee pays the exercise price for the new shares by surrendering shares held (old shares). The credit given for the old shares is based on the stock's current value. The employee gains additional shares because of the bargain element associated with the ISO; see Exhibit 1 (Part A).

This form of exercise is very attractive to the option holder, for a number of reasons. First, the exercise can be accomplished without any cash out-of-pocket. Second, the tax results are more favorable than selling sufficient stock to generate the cash necessary to exercise the option. A third benefit arises if the stock option plan contains a provision for additional options. This "reload" feature awards additional options to the employee, equal to the number of shares surrendered. The exercise price for the additional options is equal to the stock's FMV at the time of the award. Additional options on 200 shares (illustrated in Exhibit 1) would be granted at an exercise price of $125 per share. Employers use the reload feature as an incentive to encourage employees to exercise their options sooner, as opposed to waiting until they are about to expire. In Exhibit 1, the employee has taken advantage of market appreciation to secure 300 additional shares, while at the same time fixing the price on 200 new options.

Exercising ISOs in this manner is not without its pitfalls and additional complexities. It results in having to treat the ISOs under not only Secs. 83, 421 and 422, but also under the special rules of Sec. 424, and the stock exchange and basis rules under Secs. 1036 and 1031(d), all mixed together in the context of AMT. If (and when) any of that stock is sold, attempting to identify the basis of particular shares or even blocks of shares, and determining the holding period, present a recordkeeping nightmare.

The initial concern is not violating the general stock option rules under Sec. 422, particularly the holding period. The old shares used in the stock swap may come from one of three sources: (1) ISO stock, (2) stock from exercising nonqualified options or (3) stock acquired in any other way (including purchases on the open market). Care must be taken when using shares previously acquired by way of an ISO exercise to assure that the required holding period has been met. For the best tax result, those shares must be held more than one year from exercise date and two years from grant date. These are generally referred to as mature shares. Failure to meet this holding period results in a disqualifying disposition, the consequence of which is regular income taxation on the compensation received (the bargain element associated with those shares). Even the exchange of shares not meeting the holding-period requirement is considered a disqualifying disposition, as illustrated in Prop. Regs. Sec. 1.425-1(c)(3), Ex. 8. Shares not meeting the requisite holding period are considered immature shares. The impact of using mature versus immature shares is discussed later and illustrated in Exhibit 1.

The next issue is the effect of a swap on the basis of new shares acquired in an exercise. An employee does not recognize gain or loss under Secs. 424(b) and 1036 on disposing of old shares; the employee can also defer recognition of any gain due to stock appreciation. The newly acquired shares are divided into two groups. One group includes the number of shares turned in (exchange shares); the other group includes the additional shares obtained (added shares). The basis of the exchange shares is the same as the basis of the old shares surrendered. If the employee uses immature shares in the swap, the basis of the exchange shares is increased by the amount of compensation recognized on account of the disqualifying disposition; see Exhibit 1 (Part B). The added shares' basis equals the cash paid to exercise the option. This will generally be minimal and results when the current value of the exchange shares does not exactly equal the exercise cost. (Exhibit 1 does not illustrate any cash being paid.)

The holding period of the exchange shares is the same as the old shares surrendered, but only for purposes of determining whether any capital gain or loss is long-term. The date on which the employee exercises the new option is used for purposes of determining the holding period under Sec. 422(a)(1). The holding period for the added shares begins with the exercise date.

The AMT impact of the stock swap is the next hurdle. As noted, the bargain element associated with the exercise of an ISO is a preference adjustment under Sec. 56(b)(3), which specifies that Sec. 421 shall not apply to the transfer of stock acquired pursuant to the exercise of an ISO. Sec. 421(a)(1) states that no income results at the time of the exercise of an option qualified under Sec. 422(a). If income is recognized at the time of exercise for AMT purposes, the question then becomes what is the number of shares "acquired pursuant to the exercise." Is it the total shares involved in the exercise or only the added shares? Referring to Exhibit 1, even though the employee exercises 500 shares, his net gain is only 300 shares.

There does not appear to be any direct guidance in this area. However, based on authoritative sources in other closely related areas, practitioners can conclude that the preference adjustment relates only to the added shares. In Regs. Sec. 1.57-1(f), Treasury states that Sec. 57(a)(6) provides that, for each transfer of a share of stock pursuant to the exercise of a qualified stock option, an item of tax preference equal to the bargain element will be determined. That regulation refers to regulations issued under Sec. 421 for the definition of "exercise" and "transfer." (Note: Sec. 57(a)(6) was changed to Sec. 57(a)(10) in 1982, to Sec. 57(a)(3) in 1986 and finally re-designated as Sec. 56(b)(3) in 1988.)

In Rev. Rul. 80-244, the IRS ruled on the tax consequence of exchanging previously acquired qualified stock options in payment for the exercise of nonqualified stock options. The ruling involved the exercise of 2,000 shares at $6 per share, paid for with the exchange of 1,000 shares at $12 per share. In the ruling, the Service concluded that the taxpayer would recognize income under Sec. 83(a) on the 1,000 added shares multiplied by the $6 per-share bargain element. The IRS cited Regs. Sec. 1.83-7(a), which provides that income is recognized when an option is exercised and stock is transferred. If this same conclusion is applied in the AMT context, the preference adjustment should only apply to the added shares.

The basis of the shares for AMT purposes under Sec. 56(b)(3) includes the preference adjustment. Therefore, the AMT gain on subsequent disposition will be less than the regular tax gain. If AMT was incurred in the year the employee exercised the option, a credit for prior-year minimum tax could be available in the year of sale. Shares not meeting the ISO holding period due to a disqualifying disposition are not subject to AMT; therefore, the AMT basis does not include an AMT adjustment. As indicated in Exhibit 1 (Part C), the shares may have the same AMT basis as if they had met the holding-period requirements. That is because of the current income recognition for regular tax purposes and the higher regular tax basis.

The last issue deals with the identification of stock to determine the appropriate basis to offset sales proceeds on subsequent disposition. While an "average basis" methodology is authorized for mutual fund shares, Regs. Sec. 1.1012-1(c) does not provide for that approach when dealing with corporate stock. Unless a taxpayer can adequately identify the certificates or lot of stock being sold, the shares sold are first charged against the earliest of such lots on a FIFO basis. This treatment may not yield the most favorable tax result. After a few years into the life of the ISO exercises (including a number of swaps and stock splits or dividends), the tax basis waters become very murky. A taxpayer may feel fortunate in just being able to determine a FIFO basis. (For an in-depth discussion, see also Topolski, Aleshire and Rosenzweig, "ISOs and the AMT").

From David Freedland, CPA, Columbus, OH