Understanding Exercise and Release Options
This topic discusses:
Tax calculations for exercises and releases.
Payment methods for stock option exercise and release.
When exercising stock options, optionees must decide how to pay for the shares, the related taxes and fees; and how they want the shares to be issued. Depending on the option type, optionees may incur ordinary income and have to pay taxes at the time of exercise.
Some stock options can be exercised before they are vested. The optionee pays for the shares at the time of exercise and the shares are typically held in escrow until the vesting date. At that time, the vested shares are released and become fully tradable by the optionee. While the shares are held in escrow, the organization typically has full repurchase rights to the unvested shares.
For vested stock options exercises, depending upon the option type, ordinary income or alternative minimum tax (AMT) income is calculated at the time of the exercise. When an option is exercised prior to vesting the income calculation generally occurs when shares are released, free of restrictions. However, an optionee may choose to file an 83(b) election to accelerate the time at which the applicable ordinary income or Tax Preference Income for AMT is recognized.
When you calculate ordinary income Stock Administration enables you to calculate taxes by integrating with PeopleSoft Payroll for North America, using Load Default taxes or by manually entering taxes into the system for the exercise. The tax page is not available when Tax Preference Income for AMT is calculated or when ordinary income is zero. Stock Administration does not support the calculation and collection of taxes based upon Tax Preference Income for AMT pursuant to the IRS guidelines under circular E. Consult your payroll administrator or tax advisor for further information.
Tax Preference Income for AMT is calculated at exercise or release (if a restricted exercise) for ISOs and ISO/SARs exercised for shares. Ordinary income is calculated at exercise or release (if a restricted exercise) for NQs, RSAs, NQ/SARs, and ISO/SARs exercised for cash (SAR exercise). ISOs exercised after the regulatory period for termination and disability are treated as NQs and therefore ordinary income is calculated.
Stock Administration supports these exercise and release methods: cash, loan, swap, same day sale, and sell to cover, along with trade for taxes. The different share and tax payment methods affect how the system calculates the ordinary income. If an exercise method involves a sale, such as same day sale or sell to cover the system must first look to the Stock Option Plan rules for sale income methods. The methods available for each option type are FMV; sales price; or lesser of FMV or sales price. The method chosen for the option type determines what price is used when calculating the ordinary income. If only some of the shares are sold the sale income method is used only to calculate the ordinary income for the shares sold. The remaining shares (exercised but not sold) use the FMV to calculate the remaining ordinary income.
Note: Stock Administration supports only IRS tax regulations, consequently the tax calculations and discussions are based on the IRS tax code.
The following tables compare different income calculations for the various exercise and release methods.
Calculating Tax Preference Income for AMT at Exercise
|
Share and Tax Payment Method |
Calculation |
|---|---|
|
Independent of whether shares are sold at the time of the exercise (Cash, Loan, Pay Deduction, Swap, Trade, Same Day Sale, Sell To Cover) |
Tax Preference Income for AMT = Exercise Value − Cost of Shares Where: Exercise Value = Exercise FMV x Shares Exercised Cost of Shares = Grant Price x Shares Exercised |
Calculating Ordinary Income at Exercise
|
Share and Tax Payment Method |
Calculation |
|---|---|
|
No Sale Involved (Cash, Loan, Pay Deduction, Swap, Trade) |
Ordinary Income = Exercise Value − Cost of Shares Where: Exercise Value = Exercise FMV x Shares Exercised Cost of Shares = Grant Price x Shares Exercised |
|
Sale Involved (Same Day Sale or Sell to Cover) |
Ordinary Income = Exercise Value − Cost of Shares Where: Exercise Value = (Income Method Rule x Shares Sold) + (Exercise FMV x (Shares Exercised − Shares Sold)) Cost of Shares = Grant Price x Shares Exercised Income Method Rule = FMV, Sale Price or Lower of FMV or Sale Price |
Calculating Tax Preference Income for AMT at Release
AMT is calculated at Release if unvested shares are exercised and an Election 83(b) was not filed.
|
Share and Tax Payment Method |
Calculation |
|---|---|
|
Independent of whether shares are sold at the time of the release (Cash, Loan, Pay Deduction, Trade, Same Day Sale, Sell To Cover) |
Tax Preference Income for AMT = Release Value − Cost of Shares Where: Release Value = Release FMV x Shares Released Cost of Shares = Grant Price x Shares Released |
Calculating Ordinary Income at Release
|
Share and Tax Payment Method |
Calculation |
|---|---|
|
No Sale Involved (Cash, Loan, Pay Deduction, Trade) |
Ordinary Income = Release Value − Cost of Shares Where: Release Value = Release FMV x Shares Released Cost of Shares = Grant Price x Shares Released |
|
Sale Involved (Same Day Sale or Sell to Cover) |
Ordinary Income = Release Value − Cost of Shares Where: Release Value = (Income Method Rule x Shares Sold) + (Release FMV x (Shares Released − Shares Sold)) Cost of Shares = Grant Price x Shares Released Income Method Rule = FMV, Sale Price or Lower of FMV or Sale Price (FMV used determined by 83(b) filing) |
When ordinary income is recognized at exercise or release you calculate and collect the withholding taxes for US employees. You need to define the stock tax types, percentages, and limits to enable the Load Default Tax process to calculate the appropriate withholding. When you set up the various Stock Tax Types you need to define the Country Code associated with the tax you are setting up. This enables you to set up the various taxes associated with different countries. When you click the Load Default Tax the system calculates taxes based on what is set up in the tables for the country and state code at the locality for the individual. If you use Payroll for North America you can use the Calculate Tax and Update Payroll functionality to calculate the withholding due at the exercise or the release. You need to set up stock tax types for integration with Payroll for North America in order to correlate tax class to tax type.
Payroll Integration Issues
If you use Payroll for North America you can take advantage of integrated processes to calculate taxes and send tax and ordinary income directly to payroll. Otherwise, you can generate the Options Income and Tax report to send to your payroll administrator.
There are several methods optionees can use to pay for the cost of the shares and related taxes: cash, loan, stock swaps, same day sales, sell to cover, and SAR exercise.
Here's a brief discussion of each of these methods with examples illustrating how they work:
Cash
At the time of exercise, the employee is required to pay the total option price plus any withholding taxes due to the organization.
Example 1: Cash ISO Exercise
On August 22, 1998 an optionee was granted an ISO option to purchase 500 shares vesting in five annual increments beginning one year from the date of grant. The option price was $3.40 per share. On November 1, 1999 the optionee exercised the stock option for the first 100 shares. The FMV on the date of exercise was $12 per share. The calculation is:
|
Calculation Step |
Example |
|---|---|
|
Grant Price x Shares Exercised = Option Cost |
$3.40 x 100 shares = $340 |
|
Exercise FMV x Shares Exercised = Exercise Value |
$12 x 100 shares = $1,200 |
|
Exercise Value − Cost of Shares = Tax Preference Income for AMT |
$1,200 - $340 = $860 |
No withholding taxes are calculated at exercise. Thus the optionee owes the company the cost of shares ($340.00) and receives 100 shares.
Example 2: Cash NQ Exercise
On September 22, 1998 an optionee was granted an NQ option to purchase 500 shares vesting in five annual increments, beginning one year from the date of grant. The option price was $3.40 per share. On November 1, 1999 the optionee exercised the stock option for the first 100 option shares. The FMV on the date of exercise was $12 per share. The optionee is a California resident for income tax purposes. The calculation is:
|
Calculation Step |
Example |
|---|---|
|
Grant Price x Shares Exercised = Option Cost |
$3.40 x 100 shares = $340 |
|
Exercise FMV x Shares Exercised = Exercise Value |
$12 x 100 shares = $1,200 |
|
Exercise Value − Cost of Shares = Ordinary Income |
$1,200 - $340 = $860 |
Taxes are based on your setup and whether you are integrated with Payroll for North America. For example, taxes might be calculated as follows:
|
Calculation Step |
Example |
|---|---|
|
Federal |
$860 x 28% = $240.80 |
|
State |
$860 x 6% = 51.60 |
|
Social Security |
$860 x 6.2% = 53.32 |
|
Medicare |
$860 x 1.45% = 12.47 |
|
SDI |
$860 x .5% = 4.30 |
|
Total Taxes Due |
$362.49 |
Thus the optionee owes the company the sum of the cost of shares ($340.00) and the total taxes due ($362.49). The optionee pays the company $702.49 and receives 100 shares.
Loan
Loans are another form of a cash exercise. They typically require a loan agreement and a promissory note. You can select Loan as a payment method at the time of exercise, but all other aspects of loan administration are handled outside of the Stock Administration system.
All aspects of processing the exercise with the payment method of Loan are the same as those involving the payment method of Cash.
Stock Swaps
When optionees elect to exercise stock options by means of a stock swap, they are exchanging shares they already own for option shares. The shares exchanged are usually valued at the fair market value of the company's stock on the date of exercise.
In the case of a stock swap, the ordinary income or Tax Preference Income for AMT is calculated in the same manner as a cash exercise. If an optionee exercises a non-qualified stock option, ordinary income is recognized on the option shares acquired and taxes may be withheld. The shares required for the swap/trade are cancelled and sent back to either the stock plan or the treasury, according to the stock option plan rules.
The formula for calculating stock swaps is:
Cost of Share = Shares Exercised x Grant Price
Shares Required for Swap = Cost of Shares/Swap FMV
Example 1: ISO Stock Swap
An optionee was granted an ISO to purchase 500 shares vesting in five annual increments beginning one year from the date of grant. The option price was $3.40 per share. On November 1, 1999 the optionee exercised the stock option for the first 100 option shares via a stock swap. The FMV for both the exercise and swap was $12 per share. The swap rounding rule specifies to round down. The calculation is:
|
Calculation Step |
Example |
|---|---|
|
Cost of Shares |
100 x $3.40 = $340 |
|
Shares Required for Swap |
$340/$12 = 28.333 |
|
Swap Value |
$12 x 28 = $336 |
|
Additional Cash Required |
$340 - $336 = $4 |
|
Tax Preference Income for AMT |
($12 - $3.4) x 100 = $860 |
|
Total Shares Exercised |
100 |
|
Shares Required for Swap |
28 |
|
Net Shares Issued |
72 |
This assumes constructive delivery of swapped shares. The optionee owes the company $4.00 and receives 72 shares. The number of shares cancelled is 28. The cost basis for the shares issued becomes the amount due to the company divided by the net shares issued. In the above example the Cost Basis per share would be $.055555.
Example 2: NQ Stock Swap
If an optionee exercises a non-qualified stock option, ordinary income is recognized on the option shares acquired and taxes may be withheld. The shares required for the swap/trade are cancelled and sent back to either the stock plan or the treasury, according to the stock option plan rules.
On September 22, 1998 an optionee was granted an NQ option to purchase 500 shares vesting in five annual increments beginning one year from the date of grant. The option price was $3.40 per share. On November 1, 1999 the optionee exercised the stock option for the first 100 option shares using a stock swap and trade for taxes. The FMV for both the exercise and swap was $12 per share. The swap rounding rule is set to round down. The optionee is resides in California and has not met the limits for Social Security or SDI. The calculation is:
|
Calculation Step |
Example |
|---|---|
|
Cost of Shares |
100 x $3.40 = $340 |
|
Shares Required for Swap |
$340/$12 = 28 |
|
Value of Swapped Shares |
$12 x 28 = $336 |
|
Additional Cash Required |
$340 - $336 = $4 |
|
Ordinary Income |
($12 - $3.4) x 100 = $860 |
Taxes are calculated as follows:
|
Calculation Step |
Example |
|---|---|
|
Federal |
$860 x 28% = $240.80 |
|
State |
$860 x 6% = 51.60 |
|
Social Security |
$860 x 6.2% = 53.32 |
|
Medicare |
$860 x 1.45% = 12.47 |
|
SDI |
$860 x .5% = 4.30 |
|
Total Taxes Due |
$362.49 |
The trade transaction is:
|
Calculation Step |
Example |
|---|---|
|
Shares Required for Trade |
$362.49/$12 = 30 |
|
Value of Trade |
12 x 30 = 360 |
|
Additional Cash Required |
362.49 - 360 = 2.49 |
Recap of Exercise Transaction:
|
Transaction Description |
Example |
|---|---|
|
The total shares need in the swap |
2830 = 58 |
|
Optionee owes the company |
4+2.49 = 6.49 |
|
Total shares exercised |
100 shares |
|
Total shares Returned to Plan or Retired to Treasury |
58 shares |
|
Optionee receives |
42 shares |
This assumes constructive delivery of swapped shares.
For a tandem SAR, only the exercise of shares could use a stock swap. If the optionee exercises the SAR shares using a stock swap, the transaction would be handled in exactly the same manner as for the corresponding ISO or NQ example.
An option that allows unvested shares to be exercised before they are vested, such as an RSA, does not allow the use of a swap at the time of exercise. A trade is only allowed at the time the shares are released when payment is needed to cover tax liability that might be due.
Same-Day Sale
A same day sale is when the optionee finances the exercise of a stock option by immediately selling 100 percent of the shares exercised or released.
Example 1: ISO Same Day Sale
On September 22, 1998 an optionee was granted an ISO to purchase 500 shares vesting in five annual increments beginning one year from the date of grant. The option price was $3.40 per share. On November 1, 1999 the optionee exercised the stock option for the first 100 option shares and sold all 100 shares at $12.50 per share. The FMV on the date of exercise was $12 per share. The sale income method for the stock plan is the lesser of the FMV or the sale price. The calculation is:
|
Calculation Step |
Example |
|---|---|
|
Grant Price x Shares Exercised = Cost of Shares |
$3.40 x 100 shares = $340 |
|
(Lesser of FMV or Sale Price x Shares Sold) + (Shares Exercised −Shares Sold x FMV) = Exercise Value |
($12 x 100 shares) + ((100-100) x 12) = $1,200 |
|
Exercise Value − Option Cost = Tax Preference Income for AMT |
$1,200 - $340 = $860 |
Thus the total due the Company = $340.00
The company instructs the transfer agent to issue 100 shares and deliver them to the stockbroker. The company also bills the stockbroker for the cost of shares ($340.00). The optionee then receives the difference between the Total Sale Price less the Total Due Company and any brokerage fees.
Example 2: NQ Same Day Sale
On September 22, 1998 an optionee was granted an NQ to purchase 500 shares vesting in five annual increments beginning one year from the date of grant. The option price was $3.40 per share. On November 1, 1999 the optionee exercised the stock option for the first 100 option shares. The FMV on the date of exercise was $12 per share. The optionee resides in the state of California for income tax purposes. The calculation is:
|
Calculation Step |
Example |
|---|---|
|
Grant Price x Shares Exercised = Option Cost |
$3.40 x 100 shares = $340 |
|
Exercise FMV x Shares Exercised = Exercise Value |
$12 x 100 shares = $1,200 |
|
Exercise Value − Option Cost = Ordinary Income |
$1,200 - $340 = $860 |
Taxes are calculated as follows:
|
Calculation Step |
Example |
|---|---|
|
Federal |
$860 x 28% = $240.80 |
|
State |
$860 x 6% = 51.60 |
|
Social Security |
$860 x 6.2% = 53.32 |
|
Medicare |
$860 x 1.45% = 12.47 |
|
SDI |
$860 x .5% = 4.30 |
|
Taxes Due at Exercise |
$362.49 |
The total due to the organization is = $340.00 + $362.49 = $702.49
The organization instructs the transfer agent to issue 100 shares for delivery to the stockbroker and bills the stockbroker for the cost of shares and taxes ($702.49). The optionee receives the total sales price less the total due the organization and any brokerage fees.
Sell to Cover
Sometimes the optionee only wants to sell a portion of the option shares to cover the exercise cost. Many times the optionee contacts the company to have them estimate using the current FMV, the total shares that would have to be sold to cover the cost of the exercise and applicable taxes. The following examples show how these types of transactions would be handled. Example 1: NQ Sell to Cover
On September 22, 1998 an optionee was granted an NQ to purchase 500 shares vesting in five annual increments, beginning one year from the date of grant. The option price was $3.40 per share. On November 1, 1999 the optionee sells enough stock (60 shares at a sale price of $12.50) to cover the exercise of 100 shares. The optionee wants to have the remaining 40 shares issued and delivered to himself. The FMV on the date of exercise was $12 per share. The sale income method for the stock plan is set to sale price. The optionee is a California resident for income tax purposes. The calculation is:
|
Calculation Step |
Example |
|---|---|
|
Grant Price x Shares Exercised = Cost of Shares |
$3.40 x 100 shares = $340 |
|
(Sale Price x Shares Sold) + ((Shares Exercised - Shares Sold) x Exercise FMV) = Exercise Value |
(60 x $12.50) + ((100-60) x 12) = $1,230.00 |
|
Exercise Value − Cost of Shares = Ordinary Income |
$1,230 - $340 = $890 |
Taxes are calculated as follows:
|
Calculation Step |
Example |
|---|---|
|
Federal |
$890 x 28% = $249.20 |
|
State |
$890 x 6% = 53.40 |
|
Social Security |
$890 x 6.2% = 55.18 |
|
Medicare |
$890 x 1.45% = 12.91 |
|
SDI |
$890 x .5% = 4.45 |
|
Taxes Due at Exercise |
$375.14 |
The total due the company is $340.00 + $375.14 = $715.14
The company instructs the transfer agent to issue 60 shares and deliver them to the stockbroker, and issue 40 shares and deliver them to the optionee. The organization also bills the stockbroker for the option price and taxes ($702.49). The optionee receives the Total Sales Price less the Total Due Company and brokerage fees.
SAR Exercise
This method is only allowed if the option type is a tandem SAR (ISO/SAR or NQ/SAR). The underlying shares of the option are valued using the SAR FMV and the optionee is paid out the cash rights on these shares by subtracting the grant price from the SAR FMV determined on the date of the exercise. Taxes are typically due on the income at the time of the exercise for both ISO/SAR and NQ/SAR option types. Only when the individual exercises the right to the ISO shares can the preferential tax treatment be taken. The underlying shares that are used to value the cash rights are then cancelled and sent back to either the stock plan or the treasury, according to the Stock Option Plan rules specified. On September 22, 1998, an optionee was granted an ISO/SAR to purchase 500 shares that vests in five annual increments, beginning one year from the date of grant. The option price was $3.40 per share. On November 1, 1999, the optionee chose to exercise the cash right of the tandem SAR for the first 100 option shares. The SAR FMV on the date of exercise was $12 per share. The calculation is:
|
Calculation Step |
Example |
|---|---|
|
Grant Price x Shares Exercised = SAR Cost |
3.40 x 100 shares = 340 |
|
SAR FMV x Shares Exercised = Exercise Value |
$12 x 100 shares = $1,200 |
|
Exercise Value − Cost of Shares = Ordinary Income |
$1,200 - $340 = $860 |
Withholding taxes are due on all SAR exercises. The funds paid to the optionee are treated as compensation and taxed accordingly for both ISO/SAR and NQ/SAR.
Taxes are calculated as follows:
|
Calculation Step |
Example |
|---|---|
|
Federal |
$860 x 28% = $240.80 |
|
State |
$860 x 6% = 51.60 |
|
Social Security |
$860 x 6.2% = 53.32 |
|
Medicare |
$860 x 1.45% = 12.47 |
|
SDI |
$860 x .5% = 4.30 |
|
Total Taxes Due |
$362.49 |
Recap of SAR Exercise Transaction:
|
Transaction Description |
Example |
|---|---|
|
Gain on SAR Exercise |
$860.00 |
|
Taxes Due |
$362.49 |
|
Total Due Optionee |
$497.51 |
|
Shares Exercised from SAR |
100 |