Tax treatment for a cashless ISO exercise

[arfetyarfarf]

Can anyone help me understand what the tax implications of a cashless ISO exercise are, specifically in terms of the bargain element? Is the bargain element taxed as regular income or does it become part of the AMT calculation?

Just to be clear, in this scenario I'd be:

1 - Using the bargain element from a portion of my vested ISO's in order to exercise another portion of my vested ISO's.

2 - The exercised shares that I end up holding are subject to AMT, which I understand.

3 - But what about the bargain element used to "pay" to exercise those shares? How am I taxed on that?

Really appreciate the help.

[TomYoung]

"Is the bargain element taxed as regular income or does it become part of the AMT calculation?"

It's an adjustment - addition to income - for the AMT calculation.

"1 - Using the bargain element from a portion of my vested ISO's in order to exercise another portion of my vested ISO's."

I'm not sure I'm understanding exactly what you're saying here.  Is this a situation where you exercise ISO "#1" and, in effect, "sell" those acquired shares and use the "cash" so raised to exercise ISO "#2"?

If that's it, then any shares, in effect, "sold" from ISO #1 should show up as compensation to the extent of the bargain element and any shares originating from this ISO not sold by year end would be an AMT adjustment.  The same would apply to ISO #2, so if you didn't end up with ALL the shares in the grant for ISO #2 - maybe because some shares were used "for taxes" or "for exercise", then the bargain element for those shares would also show up as compensation and shares not sold by year end would also be an AMT adjustment.

A "cashless" exercise pretty much guarantees the creation of compensation since you "used" the FMV of a portion of the grant - in effect sold some - to pay for the exercise and/or the withheld taxes.

[arfetyarfarf]

Thanks so much for the response! Let me lay out some more specifics here:

I was granted ISO's as part of my compensation package. The Option Plan allows for a cashless exercise of the ISO's. Here's an example of how the cashless exercise transaction would work:

Let's say I have 10,000 vested ISO's with a strike price of $2 and a current FMV of $4. I opt for a cashless exercise where I use the bargain element ($4 FMV - $2 strike = $2 bargain element) from 5,000 vested options ($2 * 5000 = $10,000 in bargain element) to exercise the other 5,000 in vested options without laying out any cash.

I realize that I'm on the hook for AMT for the $10,000 in "gain" for the 5,000 exercised options that I now hold. But what about the $10,000 in bargain element that I used in order to do the cashless exercise? Does that also get added to the AMT calculation or does it count as part of my regular income tax? Or is there no tax liability on that?

Hope that clears it up - thanks so much!

[TomYoung · Accepted solution]

"Let's say I have 10,000 vested ISO's with a strike price of $2 and a current FMV of $4. I opt for a cashless exercise where I use the bargain element ($4 FMV - $2 strike = $2 bargain element) from 5,000 vested options ($2 * 5000 = $10,000 in bargain element) to exercise the other 5,000 in vested options without laying out any cash."

I completely understand cashless exercises.

"I realize that I'm on the hook for AMT for the $10,000 in "gain" for the 5,000 exercised options that I now hold."

Only if you don't sell them before year end.

"But what about the $10,000 in bargain element that I used in order to do the cashless exercise?"

That's compensation that shows up on  your W-2 because you sold those shares without holding them for over a year from the date of exercise and two years from the grant date.

"Does that also get added to the AMT calculation or does it count as part of my regular income tax? Or is there no tax liability on that?"

It's not an AMT adjustment it's simply "compensation", compensation that will be taxed.

[arfetyarfarf]

This is very very helpful, thank you so much.

So the summary is that the positive spread that I use to do the cashless exercise ($10k) will count as ordinary income (ouch!) and the positive spread on the exercised shares that I get to keep will get included in the AMT calculation as long as I don't sell them.

Thank you again