Odds are, the difference between your stock options' exercise price and the stock's current trading price is negligible these days. If so, check your options grant to see if you have an early exercise-option provision. If you do, you may be able to take advantage of a little unpublicized tax perk that lets you lock in future appreciation at long-term capital gains rate of 20%.
This tax election needs to be made within 30 calendar days of your early exercise and the shares become subject to forfeiture: That means if you leave the company or it goes under, you lose the shares. But if you believe your stock is going to Johnny-rocket, you could save yourself some serious tax bucks.
An early exercise doesn't allow you access to the shares any earlier than your vesting or lockup period allows. It just gives you the opportunity to take advantage of a market slump. "Any plan that does not have one is less than state of the art these days," says Rande Spiegelman, a senior manager in
investment advisory-services group in San Francisco.
The bulk of the companies offering this early exercise option are dot-coms, says Martin Nissenbaum, national director of personal-income tax planning at
Ernst & Young
. So it's been dubbed a "West Coast thing." But this planning technique does not have geographical restrictions.
When you exercise your vested
nonqualified stock options, or "nonquals," you'll owe ordinary income tax up to 40% on the difference between your exercise price and the current fair market value, a.k.a. the spread. When you exercise vested
incentive stock options, although you won't owe ordinary income tax on the spread, you may get hit by the dreaded alternative minimum tax.
Generally, you want to exercise when the spread is small. With this precarious market, odds are high that your spread has shrunk. But if your shares are not vested, what can you do?
Meet the 83(b) election.
Named after its
section in the tax code, the 83(b) election allows you to convert more of the appreciation on your exercised stock into capital gains (Read: lower taxes). The stock is subject to "forfeiture" for a year, so if you leave the company before 12 months or it goes belly up, you'll lose the shares. But if you stay, all appreciation will be taxed as capital gains, at the preferential 20% rate.
Say the exercise price on your nonquals is a nickel, the stock has plummeted to $5 a share, but your gut tells you it's coming back.
Do an early exercise. You'll owe ordinary income tax on the spread of $4.95, which includes Social Security and Medicare. Your new basis in the stock is $5, says Nissenbaum.
To lock in your upside at the long-term capital gains rate, you make the 83(b) election on the stock and notify the
Internal Revenue Service
that you're doing so within 30 days of your exercise.
Let's say the stock goes to $10 when your vesting period ends a year later and you decide to sell. Without the 83(b) election, you'd owe ordinary income tax on $9.95, at possibly 40%. With the election, you'll already have paid ordinary income tax on $4.95 and now you'll only owe $5 at the 20%. "So it's a rate play," says Spiegelman.
Of course there's a downside: Aside from having to cough up the cash to pay tax on that spread, you have to stick around for a year. And here's a not-so-unrealistic question: What if the stock never gets above $5?
You lose. You've paid tax for no reason.
You can make this 83(b) election with your incentive stock options (ISOs) and restricted stock as well. With ISOs, when you early exercise, the spread will be an alternative minimum tax adjustment. Hopefully, the spread is small enough to keep you out of AMT altogether. If you make the election within 30 days of your exercise, you no longer have to follow the ISO rule that says you must hold the stock two years from grant date and one year from the exercise date to get long-term capital gain treatment. As long as you (and the company) stick around for one year, all appreciation is capital gains.
Same goes for restricted stocks. Generally given to high-level execs and board members, employees get the shares outright but have to wait a requisite amount of time before they can sell them. But the 83(b) election must be made within 30 days of the restricted stock grant.
It's imperative that you let the IRS know that you're making this election within 30 calendar days -- not business days -- after an option exercise, or 30 days after the grant of restricted stock. Your employer should supply the appropriate form.
Like any document you mail to the IRS, send it "certified mail, return requested." In addition, you must provide a copy of this form to you employer and attach it to that year's tax return.
As with all tax planning, this needs to make economic sense and you've got to believe the stock is going up. "You've got to have patience and guts," says Spiegelman.
Seems to be the new mantra for this market.
Big note to
Herb Greenberg: As a pure-bred Jersey girl, whose family grows these things out in the back yard, if you haven't eaten a
Jersey tomato straight up with a little salt, you haven't lived.
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