Stock can be acquired through stock options in various ways:
1. Qualified incentive stock options 2. Non-qualified stock options 3. Restricted stock options 4. Exercise of a call option you bought 5. Exercise of a put option you sold
The cost basis method for each of these types of options is explained below.
Qualified Incentive Stock Option Plans:
Incentive stock option plans are "qualified" if they meet the requirements of Internal Revenue Code Section 421. To qualify for this favorable type of option treatment, the options generally must be: • granted under a plan approved by shareholders; • exercisable only by the individual employee or his or her heir; • exercisable within ten years; • held for at least two years; • have an option exercise price no less than fair market value of the stock at the time of the grant; • not held by an owner of more than ten percent of the voting power; • held by a person who is an employee of the corporation from the grant date until at least three months before exercise (one year if disabled.)
In addition, the stock acquired must be held for at least one year after exercise of the option in order to receive favorable treatment. Your employer will be able to tell you if the options you have been granted meet these conditions.
The cost basis of the stock acquired is the exercise price paid for the shares of stock acquired by option (plus any compensation income recognized if there is a disqualifying disposition.)
The favorable treatment available for this type of option is that no income is recognized when the options are granted or exercised. Tax is owed only when the stock is sold. The tax owed depends on how long the stock was held after exercise of the option:
If the stock is held for at least one year after exercise of the option, the gain is a long-term capital gain.
If it is not held for one year, some or all of the gain is classified as compensation at ordinary income tax rates. The amount of compensation is the fair market value of the stock less the exercise price at the time of exercise of the option. The remainder of the gain is still eligible for capital gains treatment.
In either case, the difference between the exercise price and the fair market value at the date of exercise is added to gross income for alternative minimum tax (AMT) calculations. The cost basis for AMT purposes is increased by the same amount if the taxpayer is subject to AMT.
A final caution is that qualified incentive stock options that first become exercisable during any tax year are reclassified as non-qualified if the total fair market value of the stock exceeds $100,000.
Non-qualified employee stock option plans:
Stock option plans are "non-qualified" if they do not meet the requirements of Internal Revenue Code Section 421. These options are also called "non-statutory." Cost basis treatment depends on whether the fair market value of the option is "readily ascertainable" on the date of the grant to the employee.
• Readily Ascertainable
If the fair market value of the option is readily ascertainable (i.e. actively traded on an established market), and the option is transferable, exercisable immediately, and has no significant restrictions, then the employee is taxed at ordinary income rates on the fair market value of the option (minus any cost paid) on the date of the grant. At exercise, the cost basis of the stock received is the sum of:
(1) the fair market value of the option at the date of the grant plus
(2) the exercise price paid for the stock.
No further income is recognized at the time the option is exercised. This is not so bad for a high growth stock because when the stock is sold, it is eligible for long-term capital gains treatment. The holding period begins the day after the option was exercised.
• Not Readily Ascertainable
The fair market value of the employee's non-qualified stock option may not be readily ascertainable because the options are not publicly-traded, are not transferable, are not exercisable immediately, or have conditions that would impact fair market value. In this case, the date of exercise determines the taxable event, rather than the date of the grant as in the "readily ascertainable" case above. At the time of exercise, ordinary income is recognized for the amount of the fair market value of the stock received less the cost of the option and less the exercise price paid. The cost basis for the stock acquired then becomes the fair market value of the stock at the date of exercise. The holding period for the stock starts the next day after the option is exercised.
Restricted stock options:
This type of option is another name for and falls under the rules for non-qualified stock options with no readily ascertainable value, as described above.
Exercise of Call Option:
If an investor owns a "call" option (the right to buy a stock at a stated price) and exercises it, the cost basis of the stock acquired is the total of the premium paid for the call option plus the exercise price.
Exercise of Put Option:
If an investor has written (sold) a "put" option (the right to sell a stock at a stated price) and it is exercised by the holder, the cost basis of the stock he owns or acquires to satisfy the put is the purchase cost of the stock less the premium he received when he sold the put.