Have you ever traded in an older vehicle for a brand new vehicle? Most of us have, and in doing so, we always have a few considerations to make. You might ask yourself: “Do I really need to trade in my old vehicle, or can I afford to pay cash for the new one and keep the older one as well?” Another consideration you can make is whether the brand new car will hold its value, depreciate, or appreciate—especially if you were lucky enough to have your older car appreciate over the years.
If you are being offered incentive stock options from your employer, you are face to face with a very similar situation. If you have been compensated with stock options prior to this new offering, you now have an even more complex decision to make. You could opt to swap some or all of your older shares of company stock for the new shares. As a financial advisor who has walked many high-level executives through the stock swap process before, I can tell you this strategy comes with its pros and cons, including when it comes to taxes. This is why we should take the time now to explain the stock swap tax consequences corporate executives should know.
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Defining a Stock Swap
First and foremost, before we explore tax consequences, we should define what exactly a stock swap is and when it might it might make sense to utilize as a strategy.
A stock swap for incentive stock options is implemented by taking employee-owned stock in which you likely have a low cost basis (from a previously exercised incentive stock option) and using it to pay for the new shares offered through a new incentive stock option. The major benefit here is the ability to purchase new employer stock without many, if any, out-of-pocket expenses. You also avoid taxable gain for regular tax purposes (as long as you hold on to the stock for more than two years before selling).
A stock swap for your incentive stock options would make the most sense to utilize if you don’t have the cash on hand to purchase the new shares, you believe that your company will continue to grow and prosper, and your purchase of additional company shares won’t create any problems by over concentrating your investment portfolio. If you aren’t sure of the answer to any of the situations mentioned, or you are looking for general guidance in completing a stock swap with your incentive stock options, it is imperative that you seek out the expert counsel of a financial advisor who has experience guiding executives through this process.
Stock Swap Tax Consequences
As a precursor, you should know that if you are looking to utilize stock shares from a prior incentive stock option exercise, you need to be sure that you have held them for more than a year. Otherwise, you could owe additional tax on those shares that would negate the benefits of the stock swap itself. However, if you have held your company shares for longer than a year after they were exercised from the incentive stock option, then you are clear to proceed further through the stock swap process.
When you bring shares of company stock to the table to swap them for new shares, you bring with them their original cost basis, which is likely low if your company has grown over time. The benefit of “swapping” them for new shares, from a tax standpoint, is that there is no taxable incident. If you were to instead sell those shares and then purchase new shares with the proceeds, you would be required to pay capital gains tax (up to 20%) on the profit made (which can be factored by subtracting the purchase price from the current market value). If you choose to implement a stock swap strategy for your incentive stock options, your next taxable incident will not be incurred until you choose to sell your shares of company stock.
For all of the previously owned shares you use to purchase the new shares, you will bring with them a carryover basis. Here’s how that works:
- You have 1,000 previously owned shares of stock with a cost basis of $10 per share and a current value of $50 per share.
- You swap those shares to purchase 2,000 shares of new stock at an incentive stock option cost of $25 per share.
- You now have 2,000 shares with no out-of-pocket expense.
- When it comes time to sell, you have a carryover cost basis of $10 on 1,000 shares, and $0 for the other 1,000 shares.
- There is no taxable incident during the swap because the old shares are used to purchase the new shares. And, while the carryover cost basis comes with the old shares, it won’t affect your tax bill until you sell the shares.
Now that we have an understanding of the basic stock swap tax consequences, let’s take a look at a form of taxation that most top-level executives will run into at some point in their career.
Alternative Minimum Tax
When talking about stock swap tax consequences with high-earning executives, there is an elephant in the room: alternative minimum tax (AMT). AMT is applicable to individuals making more than $70,000 a year and to married couples making more than $109,000 a year. It’s important to note that, in addition to your salary, your equity compensation (including incentive stock options) can be used to determine your AMT. According to the IRS, the AMT regulates the amount of income received by high-earning individuals by factoring in sources of income such as equity compensation. You can find out if you are eligible to pay AMT by going to the IRS site here.
If you are subject to AMT, you can expect to pay a minimum percentage in tax based on your income level. After you take your normal taxable income and add back any tax deductions or exclusions (including the purchase price of incentive stock options), you would determine your income level as perceived by the AMT guidelines. If your newly adjusted income (for AMT purposes) is over $187,800, you can expect to pay an alternative minimum tax of 28%. If you fall below that income level, you can expect to pay 20%. This can all be determined with the help of your CPA when you file your taxes. You can expect to pay any taxes owed at the time you file as well.
Work with Experts to Minimize Stock Swap Tax Consequences
When dealing with stock swaps and the tax consequences associated with them, we recommend executives work with a trusted CPA in addition to working with an experienced executive financial advisor. When you work with qualified experts, you give yourself the best chances for an effective stock swap and a successful financial outcome overall.
K. Wade Carpenter, CFP®, AIF®, ChFC®, CLU®, is an innovative wealth manager serving corporate executives and entrepreneurs from coast to coast. Throughout his more than 25-year career, Wade’s focus on C-level clients has made him a top strategist for equity compensation planning, including guiding executive clients through stock swaps.
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