Tax Treatment of Employee Stock Option -- Fair? Unfair?

[igorlord]

Inspired by: http://angerona.livejournal.com/665475.htmlWhat are the employee stock options? Are they a mere "promise of a bonus" or a "valueable investment position"? I know the IRS's answer. But I am after reasons/logic/fairness here

Comments

[igorlord]

I do not see a benefit in defering taxes, if I have to pay higher taxes later.

It does not matter whether you stay with the company for more than 10 years. One day I will have to leave the company, and the options from the last 10 years would have to be excercised together, which would be taxed at an insanely high rate, and would further prevent you from getting your "fair" deductions of state income taxes and such.

I would certinly prefer to pay taxes right away and then only pay much smaller taxes if I get some futher profit from the option.

[inostranka]

It all depends on how much higher the taxes and how long the deferral. If you are moving, say, from a 33% to a 35% tax bracket, it's not a big deal, but the deferral is. If you are in the 28% AMT bracket anyways, then there's no difference. Deferring taxes for 10 years does make a huge difference.

Many companies have "career retirement" programs, such that if you work there for a certain number of years and/or are close enough to retirement (precise rules vary widely), you do not have to exercise them all at once, e.g., they treat you as if you still worked there. I got this deal from ML when I left.

The tax treatment you want is covered by Qualified Stock Options. These are typically available in small start ups (which these sorts of plans were designed for in the first place). There, you pay small taxes up front and then get to claim the gain. Make sure to do that in your start up (there's a form you need to fill out to prepay the taxes).

[igorlord]

I am not sure what you are saying about ISOs.

As far as I understand it, ISOs are taxed as income when you excercise them (same as NQSO), but then, if you hold the stock for a year, you are taxed again on the whole amount (market price of stock-option price) as cap gains and are allowed to "slowly" reclaim the initial (usually AMT) income tax paid (usually over 3 years or so).

So which prepayment form are you talking about, and how does it help?

[inostranka]

Sorry, I confused the 2 issues - qualified stock options and prepaid taxes on stocks, the late hour being my only excuse.

ISOs: if the shares are held for 1 year from the date of exercise and 2 years from the date of grant, then the profit (if any) made on sale of the shares is taxed as long-term capital gain. However, you might get into AMT, as you mentioned, which you can reclaim in future years.
http://en.wikipedia.org/wiki/Incentive_stock_option

Prepaid taxes: there is a form (I don't remember the name right now) that allows you to pay taxes when you get the stock if the stock is private at the time. Then, if the company goes public you would be taxes on long term cap gain, not income.

As always with the tax code, the devil is in the details and the details tend to change, so it makes sense to do a lot more research before diving further into this.

[igorlord]

Oh, you must be talking about something like 83(a) or 86(a) or 89(a) :)

That's when your company allows you an to excerise your ISO shares before they are fully vested. You do not get to touch the shared you got this way till their original ISO vesting is complete, but they are your shares nevertheless. That 8X(a) lets you fix the price of the stock you received for such unvested ISO, pay taxes right away as if the ISO were vested, and have the future growth of the stock value be taxed at Cap Gains. Btw, it does not have to be a private stock, as far as I remember.

[syarzhuk]

but you have to pay higher taxes because you exercised them. And you had to exercise them because you switched jobs. Have you stayed with the company at your meaningless $7.50/hour position, you could exercise them when you're retired and are in the lower tax bracket. So it were your own actions that got you into this mess :)

[igorlord]

If you excersise them, you are automatically not in the lowest tax bracket but in the highest. When you excersise together 10 years worth of options (and the company is doing well), your base salary (0 or $7.50 per hour) is irrelevant.