Exercising an option grant from your company

I have a question and I hope someone can provide some insight.

My wife has options from her company, and she is going to exercise them. Now, she can exercise and sell the stock, or exercise and hold the common in the account. If she exercises and holds the common, does she still have to pay the tax on the options - or does she just pay tax when she sales the common?

For example - the options are 11 and the stock is at 15. She exercises and holds the common. Does she pay tax on the unrealized gain from the option exercise? If so, does she also pay when she sells the common (provided there is a gain)?

I am confused about the taxing situtation - any clarification is apprecated.

 

why exercise them unless you're going to cash out the common

 

in simple terms Taxes are paid on realized gains, whether they are options or stocks. if you buy and hold , then u pay taxes only in the year u sell.

 

Are the NSO or ISO options?

If she does buy and hold, for NSO's the difference is taxed immediately (withheld by the employer).

For ISO's tax there is no immediate tax liability except that the potential gain is counted for AMT. This liability does not go away even if the stock price drops. This "feature" bankrupted a fair number of dot commers a few years back. The potential advantage is that after (I forget, 1 I think) years this liability will convert into a long term gain.

It's worth talking to a tax adviser if you're considering buying and holding ISO's.

 

Yes, she'll owe taxes on the unrealized gain. My advice, therefore, is not to hold the stock. There are far too many horror stories from 2000-2001 of people doing just that in order to benefit from the lower long-term capital gains rate, only to find, one year later that their stocks had plummeted and yet they still owed taxes on the unrealized, or should I say, never to be realized gains upon exercise.

However, there is one thing you could do if you were set on holding for the year -- buy leaps puts to cover your downside. Given the low vol levels, leaps are generally extremely cheap these days, so that may be a reasonable plan. But otherwise, the risks are simply not worth the potential tax benefits, in my opinion.