Avoid Tax Hit From Company Options

Some workers who used company-granted options to buy stock in their employer this year--and who watched their holdings subsequently drop in value--have just a few more days to make some crucial tax decisions, accountants and other experts say.

Failing to take action before Dec. 31 could leave such employees with big and unnecessary tax bills, depending on the type of options involved, said Bruce Brumberg, editor in chief of MyStockOptions.com, which offers option-related advice.

“There are still some things you can do now to avoid some painful hits,” Brumberg said. Among the alternatives for reducing the tax bite are selling some or all of the shares purchased with options or selling other investments to cover options-related taxes.

Thousands of high-tech and other workers who used options granted by their employers to buy company stock in 2000 were hit broadside by unexpected tax bills after their shares plummeted with the market’s dive.

The taxes reflected the paper profits they earned when they bought the shares, regardless of the stock’s subsequent value. Some workers found they couldn’t sell their holdings for enough to pay the tax bill.

Lawmakers from technology-dependent areas, such as Silicon Valley’s Rep. Zoe Lofgren (D-San Jose), introduced legislation this year to change the law, but Congress adjourned without acting on a solution.

Using employee options to buy stock typically triggers taxes on the difference between the discounted price workers pay for shares and the stock’s closing price in the open market on the day of the purchase, said Karen Goodfriend, a Palo Alto certified public accountant.

An employee who uses options to buy company shares for $1 on a day when the shares are trading for $50, for example, would probably owe tax on the $49 paper profit--even if the stock subsequently fell in price.

The kind of tax owed depends on the type of option used to purchase the stock. Employees who use “incentive” stock options don’t owe regular income taxes on their profits. But such purchases can trigger the so-called alternative minimum tax, a parallel tax system originally designed to prevent the wealthy from avoiding taxes altogether.

Workers who have used incentive stock options--and who have since seen the stock price plummet--can avoid the alternative minimum tax by selling their shares before year-end, accountants said.

They would still owe regular short-term capital gains taxes on any difference between the price they paid for the stock and the price they received when they sold it. If the shares in the above example fell from $50 to $5, for example, the employee who sold his shares before year end would owe short-term capital gains taxes on his $4-a-share profit.

MyStockOptions.com includes a calculator to determine whether option users might be subject to the alternative minimum tax.

Workers who use the most-commonly issued type of option, called nonqualified stock options, will owe income taxes on their paper profits. Those taxes can’t be avoided by selling the shares.

That is why many financial advisors recommend immediately selling some or all shares bought with nonqualified options, to lock in the gains at that point. That way, investors can ensure they have the money needed to pay the tax bill.

Workers who choose to hold on to shares purchased with nonqualified options usually are hoping for a different kind of tax advantage: If held for a year, any subsequent profit earned on the shares can qualify for favorable long-term capital gains treatment.

But if the shares have plunged in value since they were bought, investors might be better off selling now, Brumberg said. A drop in the share price below the exercise price can be taken as a short-term capital loss, which can be used to offset other investment gains or, if the investor doesn’t have enough gains, up to $3,000 in ordinary income.

Investors who don’t want to sell their option shares can always sell other investments to pay the tax bill, Brumberg said. But again, investors should choose wisely, because selling any investment can have tax repercussions.