TAX ISSUES RELATED TO EXERCISE OF STOCK OPTIONS
This memorandum reviews the tax effects upon the exercise of "Non-Incentive
Stock Options" ("NSOs") (those options awarded to non-employee directors and
perhaps to some officers) and "Incentive Stock Options" ("ISOs") (those options
generally awarded to officers and employees).
A . Exercise of an NSO
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Upon the exercise of an NSO, the amount by which the fair market value of the
shares on the date of exercise exceeds the exercise price will be taxed to the
optionee as ordinary income. The Company will be entitled to a deduction in the
same amount, provided it makes all required withholdings on the compensation
element of the exercise. In general, the optionee's tax basis in the shares
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acquired by exercising an NSO is equal to the fair market value of such shares
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on the date of exercise. Upon a subsequent sale of any such shares in a taxable
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transaction, the optionee will realize capital gain or loss (long-term or
short-term, depending on whether the shares were held for more than 12 months
before the sale) in an amount equal to the difference between his or her basis
in the shares and the sale price.
Special rules apply if an optionee pays the exercise price upon exercise of NSOs
with previously acquired shares of stock. Except as described below with respect
to shares acquired pursuant to ISOs, such a transaction is treated as a tax-free
exchange of the old shares for the same number of new shares. To that extent,
the optionee's basis in the new shares is the same as his or her basis in the
old shares, i.e., there is a carryover of basis, and the capital gain holding
period runs without interruption from the date when the old shares were
acquired. The value of any new shares received by the optionee in excess of the
number of old shares surrendered less any cash the optionee pays for the new
shares will be taxed as ordinary income. The optionee's basis in the additional
shares is equal to the fair market value of such shares on the date the shares
were transferred, and the capital gain holding period commences on the same
date. The effect of these rules is to defer the date when any gain in the old
shares that are used to buy new shares must be recognized for tax purposes.
Stated differently, these rules allow an optionee to finance the exercise of an
NSO by using shares of stock that he or she already owns, without paying current
tax on any unrealized appreciation in the value of all or a portion of those old
shares.
B. Exercise of an ISO
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The holder of an ISO will not be subject to federal income tax upon the exercise
of the ISO, and the Company will not be entitled to a tax deduction by reason of
such exercise, provided that the holder is still employed by the Company (or
terminated employment no longer than three months before the exercise date).
Additional exceptions to this exercise timing requirement apply upon the death
or disability of the optionee. A sale of the shares received upon the exercise
of an ISO which occurs both more than one year after the exercise of the ISO and
more than two years after the grant of the ISO will result in the realization of
long-term capital gain or loss in the amount of the difference between the
amount realized on the sale and the exercise price for such shares. Generally,
upon a sale or disposition of the shares prior to the foregoing holding
requirements (referred to as a "disqualifying disposition"), the optionee will
recognize ordinary income, and the Company will receive a corresponding
deduction equal to the lesser of (I) the excess of the fair market value of the
shares on the date of transfer to the optionee over the exercise price, or (ii)
the excess of the amount realized on the disposition over the exercise price for
such shares. Currently, ISO exercises are exempt from FICA and FUTA taxes and a
disqualifying disposition is exempt from employer withholding.
A special rule applies if an optionee pays all or part of the exercise price of
an ISO by surrendering shares of stock that he or she previously acquired by
exercising any other ISO. If the optionee has not held the old shares for the
full duration of the applicable holding periods before surrendering them, then
the surrender of such shares to exercise the new ISO will be treated as a
disqualifying disposition of the old shares. As described above, the result of a
disqualifying disposition is the loss of favorable tax consequences with respect
to the acquisition of the old shares pursuant to the previously exercised ISO.
Where the applicable holding period requirements have been met, the use of
previously acquired shares of stock to pay all or a portion of the exercise
price of an ISO may offer significant tax advantages, particularly a deferral of
the recognition of any appreciation in the surrendered shares in the same manner
as discussed above with respect to NSOs.
C. Alternative Minimum Tax
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The "alternative minimum tax" is paid when such tax exceeds a taxpayer's regular
federal income tax. The alternative minimum tax is calculated based on
alternative minimum taxable income, which is taxable income for federal income
tax purposes, modified by certain adjustments and increased by tax preference
items.
The spread under an ISO - i.e., the difference between (a) the fair market value
of the shares at exercise and (b) the exercise price - is classified as
alternative minimum taxable income for the year of exercise. Alternative minimum
taxable income may be subject to the alternative minimum tax. However, a
disqualifying disposition of the shares subject to the ISO during the same year
in which the ISO was exercised will generally cancel the alternative minimum
taxable income generated upon exercise of the ISO.
When a taxpayer sells stock acquired through the exercise of an ISO, generally
only the difference between the fair market value of the shares on the date of
exercise and the date of sale is used in computing the alternative minimum tax.
The portion of a taxpayer's minimum tax attributable to certain items of tax
preference (including the spread upon the exercise of an ISO) can be credited
against the taxpayer's regular liability in later years to the extent that
liability exceeds the alternative minimum tax.
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