Probate & Trust Law Section Conference Manual ... - Minnesota CLE

The Well-Prepared Executive: Personal Wealth Preservation Strategies
i. The exercise of an ISO and the receipt of
the stock occurs when substantially all of the rights
to the stock have been transferred. Treas. Reg. §
1.421-7(g). A transfer may take place for tax
purposes before the transfer is evidenced on the
corporation’s books so long as the transfer is
evidenced within a reasonable time. Id. For
example, the IRS ruled that an ISO exercise and
transfer of ISO stock took place when an employee
delivered the notice of exercise and full payment,
even though the stock certificate is not issued until
later. Rev. Rul. 70-335, 1970-1 C.B. 111; see also,
Becker v. Commissioner, 378 F.2d 767 (3 rd Cir.
1967).
c. Sale of Stock
When the executive sells the stock acquired
by exercising an ISO, the full appreciation in value
of the stock since exercise of the ISO is subject to
tax as capital gains. Thus, ISOs provide two
benefits: (i) the executive generally defers tax until
the underlying stock is sold; and (ii) all of the gain
from the time of exercise of the ISO is treated as
capital gains.
2. Example of ISO Income/Capital Gains Tax
Consequences
Facts
Year 1: ISOs for 10,000 shares granted at $10
exercise price when fair market value of stock is
$10.
Year 3: ISOs are exercised when fair market value
of stock is $15.
Year 5: Executive sells stock for $20.
Tax Consequences to Executive
Year 1 Grant:
Executive recognizes no income.
Year 3 Exercise:
Executive recognizes no income (except for
potential AMT)
Year 5 Sale:
Executive has $100,000 capital gain ($200,000 -
$100,000 exercise price) resulting in $20,000 tax (at
20% capital gains rate).
Cash Flow Consequences:
Executive nets $80,000 ($200,000 - $100,000
exercise price - $20,000 capital gains tax)
(excluding AMT considerations).
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3. Holding Period Requirement and
Disqualified Dispositions
a. To obtain the favorable ISO tax
consequences, the executive must not dispose of the
stock received on the exercise of an ISO before the
later of (i) 2 years from the grant of the ISO or (ii) 1
year from the exercise of the ISO. IRC § 422(a)(1).
Thus, both holding periods must be satisfied.
i. A disposition of ISO stock generally
means any sale, exchange, gift or other transfer.
IRC § 424(c) allows the following exceptions: (a) A
transfer of ISO stock by a deceased employee to an
estate or a transfer by bequest or inheritance; (b) An
exchange of ISO stock in a tax-free exchange under
IRC §§ 354, 355, 356 or 1036; (c) A pledge of ISO
stock; (d) A transfer of ISO stock between spouses
or incident to divorce within the meaning of IRC §
1041; (e) An acquisition of ISO stock in joint
ownership with right of survivorship or the
subsequent transfer of ISO stock into such joint
ownership; and (f) A transfer of ISO stock by an
insolvent employee in bankruptcy to a bankruptcy
trustee or subsequent creditor.
b. Failure to satisfy the holding period
requirement does not disqualify the ISO but rather
results in a disqualifying disposition. Any gain
recognized by the executive on a disqualifying
disposition will first be treated as ordinary income
to the extent of the difference between the stock’s
fair market value on the date the ISO was exercised
and the exercise price. IRC § 421(b). Any
remaining gain will be treated as long-term capital
gain if the executive held the stock after the exercise
of the ISO for at least one year or short-term capital
gain if the executive did not hold the stock for a
year.
c. In many cases, the executive will not satisfy
the requirement that they hold the stock for one year
from the exercise date. This is especially true for
executives who hold ISOs in a start-up company
that goes public or a company that is sold.
4.
Alternative Minimum Tax Issues
a. AMT Adjustment
Although the exercise of an ISO does not
result in a regular tax liability, the exercise may
result in AMT. The difference between the fair
market value of the ISO stock on the exercise date
and the exercise price is treated as an adjustment for
AMT purposes. IRC § 56(b)(3). The starting point
in calculating AMT is the taxpayer’s regular taxable