I exercised stock options for a non-public company to avoid losing them. Why do I pay taxes on gains I cant realize / options I cant sell? Does cost of purchase offset?

[TomYoung]

I assume that the taxable income here is a result of the exercise, reported to you on a W-2?

Assuming these were NonQualified stock options then the "spread" between what you paid to exercise the options and the "fair market value" of the stock acquired is considered "compensation"  and, like compensation paid in cash, gets taxed. 

I'm not sure what you mean by "does cost of purchase offset?"  Your cost of purchase comprises a portion of you basis in the stock.  That "spread" comprises the rest of your basis in the stock.  In other words, your basis per share is the same as the per share "fair market value" used by the employer to calculate the compensation. 

        (GROSS number of shares exercised) x (per share "fair market value") =  compensation reported on W-2

Apparently you DID figure you were getting something of value here, otherwise you wouldn't have exercised.

Tom Young

[starrmin]

Thanks for this feedback.  If, in future tax years, the estimated price of the stock goes down and/or the option expires before it's able to be sold (as it's a private company currently / no sale option), would any of that tax paid this year (or the original purchase price) be adjusted out of income in future years (e.g. refunded back to me)?

[MountainGoat]

Hi TomYoung,

I am wondering if you can elaborate further?  I own certain warrants that entitle me to purchase shares in a privately held technology company. This small enterprise has had zero stock sold at arm's length in its history, although a 409A valuation was done in July 2015 at the time an ISO program was introduced (my warrants were issued before the ISO program was introduced).  In the interim, the company's business has gone sideways to down.

My warrants vested in the period from 2012 - 2017.  I was dismissed from the company less than 3 month ago and would like intelligently to exercise my rights to purchase the stock before my grant expires next year.  Because there is no market for the stock, I have no ability to re-sell the shares, nor to establish a fair market value for them.  This puts me into an AMT quandary as far as I can determine.

Because my warrants include transfer rights and are not part of an organized ISO program, I believe they qualify as Non-Statutory Options per Publication 525.  However, this document does not include an example for reporting the exercise of a non-statutory option grant under AMT when there is no FMV for company's shares on the date of exercise.  The value to me in owning the shares is to participate in any eventual sale (not expected within the first year of owning the stock).  I am unsure what amount to record under AMT requirements as the difference between my exercise price and the FMV.  What guidance can you provide in this situation?

[TomYoung]

I would guess that the warrants would be considered non-statutory options. 

In the case of non-statutory options there are no specific AMT issues.  This is in contrast to Incentive Stock Options where there are AMT issues if the shares are not sold by year end in the year of exercise.  The reason for this is the special tax treatment accorded ISOs.  With ISOs you don't recognize compensation income in the year of exercise while with Non-statutory programs you do recognize compensation in the year of exercise.

The only issue you face I'd guess is what amount of compensation to recognize on the exercise and supporting that estimate.  There's nothing that says the compensation can be $0.

[MountainGoat]

Thank you - that's very helpful.  Do you suppose there is a precedent for recognizing the exercise price as compensation?  If so, how does one report the cost of the option, which effectively reduces the net investment to zero?  Is the tax payer expected to establish a "FMV" price above the exercise price merely to record a "profit" that can be taxed?

[TomYoung]

"Do you suppose there is a precedent for recognizing the exercise price as compensation?" 

The exercise price is definitely not compensation.   The exercise takes real money out of your pocket and there's no way money out of your pocket can be considered compensation to you.  The compensation associated with an exercise is the spread between what you paid to exercise and the value of the shares received.  There's nothing wrong at all - assuming you can support the notion - that what you received is no more valuable than the price you paid and, accordingly, there's no compensation associated with the exercise.