Employee stock options cashless exercise

Subject: Tax Code - Cashless Option Exercise.

Last-Revised: 19 Oct 2014.

Contributed-By: Art Kamlet (artkamlet at aol), Chris Lott (contact me)

This article discusses the tax treatment of an employee's income that derives from stock options, specifically the case in which an employee exercises non-qualified stock options without putting any money down.

First, a digression. What is a non-qualified option? A non-qualified stock option is the most popular form of stock option given to employees. Basically, an employee who exercises a non-qualified option to buy stock has to report taxable income at the time of the purchase, and that income is taxed as regular income (not as a capital gain). In contrast, an incentive stock option (ISO) dodges these tax bullets, but is more complicated because employees who receive ISOs have to worry about alternative minimum tax (AMT). Unfortunately some companies are sloppy about naming, and use the term ISO for what are really non-qualified stock options, so be cautious.

Next, what is a cashless exercise? Basically, this is a way for an employee to benefit from his or her stock option without needing to come up with the money to purchase the shares. Any employee stock option is basically a call option with a very long expiration; hopefully it's also deep in the money (also see the FAQ article on.

In a typical cashless exercise of non-qualified stock options (you can tell it is non-qualified because the W-2 form suddenly has a huge amount added to it for stock option exercise), here is what happens. Let's use E as the Option Exercise Price and FMV as the fair market value of the shares. The employee needs to pay E as part of the option exercise. But this is a cashless exercise, so the company (or, more likely, a broker acting as the company's agent) lends the employee that amount (E) for a few moments. The stock is immediately sold, for FMV. The broker takes back the amount, E, loaned to the employee for the exercise, and pays out the difference, FMV-E. The broker will almost certainly also charge a commission.

Ok, now for those fortunate people who are able to do a cashless stock option exercise, and choose to do so, how do they report the transaction to the IRS? The company imputes income to the employee of the difference between fair market value and exercise price, FMV-E. That amount is added to the employee's W-2 form, and hopefully shows up in Box 12 indicated by a V. The amount FMV-E is the imputed income. Again, you will notice FMV-E is not only what the broker paid out, it is also the imputed income amount that shows up in the W-2 form.

The Schedule D sales amount reported by the broker is FMV minus any commission. The employee's cost basis is the FMV. So the FMV is the sales price, and the Schedule D for this transaction will show zero (if no commission was charged) or a small loss (due to the commission).

In certain situations, FMV might differ slightly from the price at which the shares were sold, depending on how the company does it, and if so, the company should report the FMV to the employee. Then the Schedule D must be completed appropriately to show the short-term gain or loss (the difference between the sales price and FMV).

For extensive notes on stock and option compensation, visit the Fairmark site with articles by Kaye Thomas:

Julia K. O'Neill offers an extensive discussion of the differences between incentive stock options and non-qualified options:

Cashless Exercise of Nonqualified Options.

Tax rules for cashless exercise of nonqualified stock options.

Some employers make it easier for option holders to exercise their options by providing a method of "cashless exercise." Usually the company makes arrangements with a brokerage firm, which loans the money needed to buy the stock. The brokerage firm sells some or all of the stock immediately, with part of the proceeds being used to repay the loan — often on the same day the loan was made. The remaining proceeds (net of any withholding and brokerage commissions or other fees) are paid to the option holder.

Not all companies permit this method of exercise. Some companies want to encourage option holders to retain the stock so they'll have an ongoing stake in the business. Others may be concerned that sales executed in this manner will depress the price of their stock. Review your option documents, or check with the company, to see if this method is available.

Tax consequences.

In general, the tax consequences of a cashless exercise are the same as the tax consequences of two separate steps:

Exercising the option. This step generally requires you to report ordinary compensation income. If you're an employee, a withholding requirement applies as well. The income (and withholding, if any) will be reported to you on Form W-2 (if you're an employee) or Form 1099-MISC (if you're not). For details see Exercising Nonqualified Stock Options. Selling the stock. This step requires you to report capital gain or loss (which in this case is obviously short-term). You'll receive Form 1099-B telling you the amount of the proceeds (not the amount of gain or loss) from the sale. For details see Sale of Nonqualified Option Stock.

Frequently asked questions.

We often see confusion on the following points:

Q: My gain from exercising the option appears on my Form W-2 as wages — but Form 1099-B reports the full amount of proceeds, including the gain. Why is the same amount reported twice?

A: The same amount is reported twice, but it's not taxed twice. Form 1099-B shows how much you received for selling the stock. When you figure your gain or loss, the amount reported on your W-2 is treated as an additional amount paid for the stock. (In other words, it increases your basis.) The effect is to reduce your gain or increase your loss, so you're not double taxed. See Sale of Stock from Nonqualified Options.

Q: Why do I have gain or loss when I sold the stock at the same time I exercised?

A: Usually there's a small gain or loss to report, for two reasons. First, the amount reported on your W-2 as income is usually based on the stock's average price for the day you exercised your option, but the broker may have sold at a price slightly above or below that average price. And second, your sale proceeds are likely to be reduced by a brokerage commission, which can produce a small loss. But any gain or loss should be minimal.

Cashless Exercise.

DEFINITION of 'Cashless Exercise'

A transaction that is used when exercising employee stock options (ESO). Essentially, what you do here is borrow enough money from your broker to exercise the options. You then simultaneously sell enough shares to pay for the purchase, taxes, and broker commissions.

BREAKING DOWN 'Cashless Exercise'

What you are doing is technically called buying on margin. The brokerage lets you buy on margin in this case because they know there will be a quick repayment. The advantage of this technique is you don't need the cash on hand.

Cashless Exercise of ISOs.

8. Principles of Risk and Insurance 9. Analysis and Evaluation of Risk Exposure 10. Property, Casualty and Liability Insurance 11. Health Care Insurance and Cost Management 12. Disability Insurance 13. Long-Term Care Insurance 14. Life Insurance.

22. Employee Stock Options 23. Stock Plans 24. Non-Qualified Deferred Compensation 25. Characteristics, Uses and Taxation of Investments 26. Types of Investment Risk 27. Risk and Return Measures 28. Investment Theory and Portfolio Development.

36. Basis 37. Depreciation And Cost-Recovery Concepts 38. Tax Consequences 39. Alternative Minimum Tax 40. Tax Reduction And Management Techniques 41. Passive Activity And At-Risk Rules 42. Tax Implications of Special Circumstances.

50. Gifting 51. Incapacity Planning 52. Estate Tax 53. Liquidity, Powers of Appointment, and Trusts 54. Charitable Transfers 55. Use Of Life Insurance In Estate Planning 56. Valuation Issues.

64. Estate Planning For Non-Traditional Relationships.

The grant of the options entails no taxable event. No additional ordinary income arises from the exercise of the options, but Stone will incur an alternative minimum tax adjustment upon exercise of the options for $40,000 (($20-$12) x 5,000) and possibly cause him to pay AMT. Stone's long term capital gain would be $190,000 ($250,000 - $60,000). Adjusted taxable basis would be $12 per share. Stone's capital gain for AMT purposes would be $150,000 upon the sale of the shares at $50.

$250,000-$100,000 (adjusted basis would be $20 per share, $12 is the strike price and $8 is the AMT adjustment for the amount by which the option was in the money at exercise.) Sale of the shares in the same calendar year as exercise would result in W-2 income of 5,000 x ($20-$12) = $40,000.