taxation after a corporate acquisition event: unexercised bu

derkire · Joined: 10 Feb 2008 Posts: 6

Consider the following scenario:

1. Company A buys company B.
2. Employees of B hold some vested, but un-exercised incentive stock
options (ISO).
3. As part of the buyout process, these options get exercised and
paid in cash by A.

My question is, should the cash paid be treated as a short term
capital gain or as regular income?

========================================= MODERATOR'S COMMENT:
Ordinary income treatment, flowing to a W-2 form.

--
>
>
>
>
>
>
>
>
>
>

Archived from group: misc>taxes>moderated

Alan · Joined: 12 Oct 2007 Posts: 93

derkire@gmail.com wrote:
> Consider the following scenario:
>
> 1. Company A buys company B.
> 2. Employees of B hold some vested, but un-exercised incentive stock
> options (ISO).
> 3. As part of the buyout process, these options get exercised and
> paid in cash by A.
>
> My question is, should the cash paid be treated as a short term
> capital gain or as regular income?
>
> ========================================= MODERATOR'S COMMENT:
> Ordinary income treatment, flowing to a W-2 form.
>
As the options are being exercised and sold on the same day, the
statutory holding period for favorable treatment has not been
met. As such, this is a disqualifying disposition. The difference
between market value and the exercise price is all compensation
(ordinary income). As the moderator said.. it should be reflected
on a W-2. Even if it is not on a W-2, the gain gets entered on
Line 7 of the tax form.

From a technical point of view... your ordinary gain gets added
to what you paid to arrive at an adjusted cost basis. The
difference between the sales proceeds and this adjusted basis is
your short term capital gain or loss. This can actually happen
if there are commissions and or fees paid as part of the
transaction and market value and sales proceeds are not equal.

--
>
>
>
>
>
>
>
>
>
>

joeu2004 · Joined: 25 Aug 2007 Posts: 28

On Feb 9, 9:44 pm, derk...@gmail.com wrote:
> 1. Company A buys company B.
> 2. Employees of B hold some vested, but un-exercised incentive
> stock options (ISO).
> 3. As part of the buyout process, these options get exercised
> and paid in cash by A.
> My question is, should the cash paid be treated as a short term
> capital gain or as regular income?

I am suspicious of the description of the circumstances.
Consequently, I would be wary of responders' interpretation
and their answers.

At issue is the statement that options "get exercised and
paid in cash by A" in Step 3.

Do you mean that you were give the choice to exercise
those options, which you did? For an option to be exercised,
__you__ must pay the exercise price. Of course, there is
no way that the company can force that to happen "as part
of the buyout process".

In that case, it is a normal disqualifying disposition, as some
responders have said.

Or do you really mean that the company paid you some
amount of cash (either the exercise price or the FMV) for
the options that your held?

In that case, this is an exchange, not an exercise. But
because it is an exchange for employee compensation (the
employee stock option), I believe the entire cash amount
received should be treated as compensation (i.e. wage
income).

In either case, your company should be the best source
of information for how to treat this transaction. Although the
company might assert that they cannot give "tax advice",
it is standard practice (if not a legal requirement) for them
to provide "tax information" -- that is, general information
about the tax consequences.

Since this regards an employee situation, contact personnel,
not investor services. In fact, the latter is likely to give you
the wrong information -- information about open-market stock
options, not employee stock options, which are treated very
differently, as you may know.

--
>
>
>
>
>
>
>
>
>
>

derkire · Joined: 10 Feb 2008 Posts: 6

Everybody: thanks for the replies, this was very helpful.

Moderator, thanks for the reply.

Joeu2004 brought up an interesting point: The employees were not
offered explicitly to exercise (and then sell) the options per se. In
fact, the transaction may very well have been structured as an
"exchange" of the option for its FMV, which was the takeover share
price minus the option original price.It sounds like this would
(probably) mean the proceeds are treated as ordinary income.

But what if the transaction was indeed structured as an "exercise-then-
sell". Does that make a difference? Would the company have a (self-
interest, tax) reason NOT to structure the transaction as a two-step
process, since this would enable employees to qualify for 28% STCG tax
versus up to 35% ordinary income tax? Why would the company not try to
make the employees happier by doing that?

Alan, I was not angling for the 15% LTCG "favorable treatment", if
that is what you meant. Only the favorable treatment of 28% STCG tax
versus ordinary income tax.

--
>
>
>
>
>
>
>
>
>
>

joeu2004 · Joined: 25 Aug 2007 Posts: 28

PS....

On Feb 10, 9:41 pm, derk...@gmail.com wrote:
> the transaction may very well have been structured as an
> "exchange" of the option for its FMV, which was the takeover
> share price minus the option original price.

In my previous response, I asserted that the exchange probably
resulted in more income for you. But as you describe, it sounds
like the exchange had the same or nearly the same effect as if
all options had been exercised.

> But what if the transaction was indeed structured as an
> "exercise-then-sell".
> [...] since this would enable employees to qualify for 28% STCG
> tax versus up to 35% ordinary income tax?

In my previous response, I assumed that you are referring to a
cashless exercise; therefore, there would be no (or negligible)
STCG (most likely a small loss).

But if by "exercise-then-sell", you are including selling later, then
theorerically, yes, there could be a STCG component. But of
course, the stock you would be selling later would have to be
stock in the Company A.

(And quite frankly, I don't remember whether or not there is a
special case in the reorganization statute for exercised, but held
ISO shares. No time now to look it up.)

> Would the company have a (self-interest, tax) reason NOT to
> structure the transaction as a two-step process

There would indeed be yet-another reason why the company
would not want to permit you to exercise, but hold the ISO shares.
You would not want it, either.

The exchange rate is based on the number of outstanding shares
and FMV of those shares in both companies on the record date.
If the company allowed you to exercise and hold ISO shares, the
record date would have to be some time after all employees with
ISOs announced their intention and exercise their options, if that
is their decision. As I said before, the company loses some
control over the timeline.

But an employee's decision to exercise and hold v. a cashless
exercise would probably depend on the knowing the exchange
rate -- that is, the value of their exchanged stock after the
acquisition is completed. It's a chicken-and-egg problem.

--
>
>
>
>
>
>
>
>
>
>

joeu2004 · Joined: 25 Aug 2007 Posts: 28

On Feb 10, 9:41 pm, derk...@gmail.com wrote:
> the transaction may very well have been structured as an
> "exchange" of the option for its FMV, which was the takeover
> share price minus the option original price.It sounds like this
> would (probably) mean the proceeds are treated as ordinary
> income.

The key point is: the __entire__ amount received would be
ordinary income, not the difference between the FMV and the
exercise price.

> But what if the transaction was indeed structured as an
> "exercise-then-sell". Does that make a difference?

Yes. As both Alan and I stated, that is the disqualifying
disposition scenario. The ordinary income would be the
difference between the FMV and the exercise price.

> Would the company have a (self-interest, tax) reason NOT
> to structure the transaction as a two-step process

Sure: to facilitate and simplify the acquisition process. As
I explained previously, only you could exercise the stock
option. Moreover, the company cannot force you to exercise
the stock option. Either it would have to present you with a
"use it or lose it" choice, or it could offer some other alternative
of value.

In any case, the company loses some control over the
timeline for completing the acquisition process.

> since this would enable employees to qualify for 28% STCG
> tax versus up to 35% ordinary income tax?

Not so. The only difference is the amount of ordinary income
that would be taxable. With a cashless exercise, you would
receive less, so less than would be taxable .

> Why would the company not try to make the employees
> happier by doing that?

I question whether it would make employees happier. I
suspect that the exchange for cash resulted in more after-tax
income. Do the math and see for yourself.

--
>
>
>
>
>
>
>
>
>
>

derkire · Joined: 10 Feb 2008 Posts: 6

On Feb 11, 11:06 am, joeu2004 wrote:
> On Feb 10, 9:41 pm, derk...@gmail.com wrote:
>
> > the transaction may very well have been structured as an
> > "exchange" of the option for its FMV, which was the takeover
> > share price minus the option original price.It sounds like this
> > would (probably) mean the proceeds are treated as ordinary
> > income.
>
> The key point is: the __entire__ amount received would be
> ordinary income, not the difference between the FMV and the
> exercise price.
>
> > But what if the transaction was indeed structured as an
> > "exercise-then-sell". Does that make a difference?
>
> Yes. As both Alan and I stated, that is the disqualifying
> disposition scenario. The ordinary income would be the
> difference between the FMV and the exercise price.
>
> > Would the company have a (self-interest, tax) reason NOT
> > to structure the transaction as a two-step process
>
> Sure: to facilitate and simplify the acquisition process. As
> I explained previously, only you could exercise the stock
> option. Moreover, the company cannot force you to exercise
> the stock option. Either it would have to present you with a
> "use it or lose it" choice, or it could offer some other alternative
> of value.
>
> In any case, the company loses some control over the
> timeline for completing the acquisition process.
>
> > since this would enable employees to qualify for 28% STCG
> > tax versus up to 35% ordinary income tax?
>
> Not so. The only difference is the amount of ordinary income
> that would be taxable. With a cashless exercise, you would
> receive less, so less than would be taxable .
>
> > Why would the company not try to make the employees
> > happier by doing that?
>
> I question whether it would make employees happier. I
> suspect that the exchange for cash resulted in more after-tax
> income. Do the math and see for yourself.
>
> --

Joeu2004,

I just realized that I left out some details that are important,
namely:

Company A = public
Company B = private
All-cash transaction

Hence, when I talk about "exercise-then-sell" this is all a private
transaction
at a pre-set share price, for cash. Company A stock is never involved,
The exercise would be for Company B stock, which in turn would be
bought by Company A for cash, at the predetermined share price.

Does that make a difference to the analysis? With the additional
constraints,
can you see a way that a two-step exercise+sell disposition of the
vested
options could be structured so as to qualify for STCG?

--
>
>
>
>
>
>
>
>
>
>

joeu2004 · Joined: 25 Aug 2007 Posts: 28

On Feb 12, 7:33 am, derk...@gmail.com wrote:
> I just realized that I left out some details that are important,
> namely:
> Company A = public
> Company B = private
> All-cash transaction
>
> Hence, when I talk about "exercise-then-sell" this is all a private
> transaction at a pre-set share price, for cash. Company A stock
> is never involved, The exercise would be for Company B stock,
> which in turn would be bought by Company A for cash, at the
> predetermined share price.

And let's not forget the fact that all this -- exercise of ISOs
and subsequent sale (by you to Company A) -- occurs
within 12 months of the exercise. Right?

> Does that make a difference to the analysis?

Not really. Since you are selling ISOs within 12 months of the
exercise, the difference between the selling price (the amount
Company A pays) and the exercise price (what paid Company
B when you exercised the ISO) is treated as ordinary income,
specifically wage income. That's all there is to it.

> With the additional constraints, can you see a way that a
> two-step exercise+sell disposition of the vested options
> could be structured so as to qualify for STCG?

If you paid commission and SEC fees to a broker for the
transactions, the commission and fees would effectively be a
short-term capital loss. But I have never heard of brokerage
fees being paid by the employee in this kind of transaction
resulting from a merger or acquisition.

We seem to be beating a dead horse.

--
>
>
>
>
>
>
>
>
>
>

derkire · Joined: 10 Feb 2008 Posts: 6

On Feb 12, 6:42 pm, joeu2004 wrote:
> On Feb 12, 7:33 am, derk...@gmail.com wrote:
>
> And let's not forget the fact that all this -- exercise of ISOs
> and subsequent sale (by you to Company A) -- occurs
> within 12 months of the exercise. Right?
>

Ok. I think I get the point, although I had difficulty
understanding it earlier, amid the other technicalities.

For ISOs, taxation is either

1.. regular income
or
2. long term capital gains (LTCG)

There is no middle ground (that is, Short Term Capital Gain treatment
just is not possible, no way, no how).

Right or wrong? (and I'll stop beating the horse)

--
>
>
>
>
>
>
>
>
>
>

joeu2004 · Joined: 25 Aug 2007 Posts: 28

On Feb 12, 9:06 pm, derk...@gmail.com wrote:
> On Feb 12, 6:42 pm, joeu2004 wrote:
> For ISOs, taxation is either
> 1.. regular income
> or
> 2. long term capital gains (LTCG)
>
> There is no middle ground (that is, Short Term Capital Gain
> treatment just is not possible, no way, no how).
> Right or wrong?

Essentially right, for my interpretation of the facts as you have
presented them. Here is the complete picture. Hope it does
not obfuscate things.

For ISOs held at least 1 year and a day after exercise __and__
2 years and a day after grant, all of the difference between the
exercise price and selling price (less commision and fees) is
treated as long-term gain (loss).

Otherwise, if either of the above conditions is not met:

a. The difference between exercise price and fair market value
(FMV) on the exercise date is treated as compensation and
taxed at the ordinary income tax rate.

Exception: If the FMV is less than the exercise price, the
compensation is zero; ergo, there is no ordinary income tax.

b. The difference between the FMV (now the basis of the stock)
and the selling price (less commission and fees) is treated
as short-term capital gain (loss).

Note that in the exception case in #a, all of the difference
between FMV and selling price (less commission and fees)
would be treated as short-term capital gain (loss).

At issue is the determination of the FMV.

Normally, the FMV on the exercise date is determined by the
company, within certain flexible guidelines set by regulations.

For publicly-trade stock, typically the FMV is either the closing
price or the average of the high and low prices for the day (or
"recent" time frame).

But in the case of an exercise and sale on the same day, it
has become common practice (if not dictated by regulation)
to use the selling price as the FMV. That is why in #b above,
there is negligible short-term gain (loss), namely only the
commission and fees, if any. (Probably none in your case.)

If the sale is on a different day, for privately-held stock
(presumably not traded frequently), the FMV on the exercise
date is determined by a "recent" sale (within a regulated time
frame) or by a complex valuation of the company. In my
opinion, in your case, the FMV would be set by the price that
Company A is willing to pay for the Company B stock; thus, I
believe the FMV is the selling price. So once again, #b would
result in negligible short-term gain (loss), and probably none.

Hope that helps and disposes of all your questions.

--
>
>
>
>
>
>
>
>
>
>

derkire · Joined: 10 Feb 2008 Posts: 6

On Feb 13, 1:40 pm, joeu2004 wrote:
> On Feb 12, 9:06 pm, derk...@gmail.com wrote:
>
> > On Feb 12, 6:42 pm, joeu2004 wrote:
> > For ISOs, taxation is either
> > 1.. regular income
> > or
> > 2. long term capital gains (LTCG)
>
> > There is no middle ground (that is, Short Term Capital Gain
> > treatment just is not possible, no way, no how).
> > Right or wrong?
>
> Essentially right, for my interpretation of the facts as you have
> presented them. Here is the complete picture. Hope it does
> not obfuscate things.
> ...
>Hope that helps and disposes of all your questions.

It does, thank you. If I dare summarize:

The implied gain (FMV-EV), if any, of an OPTION EXERCISE is always
recognized
immediately as regular income. Any further gain (or losses) on shares
subsequently
held are long-or-short term capital gains, depending on the holding
period.

Likewise, any gain on an OPTION SALE/EXCHANGE is regular income.
(does that apply to all kinds of options, including publi

Special case:

If one exercises options while share price == exercise price,
the implied gain is 0, hence there is no regular income to recognize
on the option exercise.

Moreover (care to correct this if I got any details wrong?):

If additionally one exercises "early", aka. before vesting, and file a
properly worded 83(b) election within 30days, the 1-year clock to
achieve LTCG status starts ticking at the time of filing (or the time
of the early excercise/delivery?). Additionally, for LTCG treatment,
it is required that the option grant itself is at least 2 years old at
the time of sale.

Did I screw anything up?

--
>
>
>
>
>
>
>
>
>
>

joeu2004 · Joined: 25 Aug 2007 Posts: 28

On Feb 14, 2:09 pm, derk...@gmail.com wrote:
> If I dare summarize:
> The implied gain (FMV-EV), if any, of an OPTION EXERCISE
> is always recognized immediately as regular income.

No. I think I was quite clear that that is not true in one case
for ISOs (which are different from nonqualified employee stock
options).

> Any further gain (or losses) on shares subsequently held
> are long-or-short term capital gains, depending on the holding
> period.

I think I was also quite clear that there is no long-term gain
(loss) for ISOs in the case where some of the appreciation
over the exercise price is recognized as ordinary income --
namely, the "otherwise" scenario, which I should have reiterated
that it is called a "disqualifying disposition".

I don't seem be helping clear things up. I suggest that you
read the explanation at http://fairmark.com/execcomp/index.htm .

PS: I neglected to mention the issue with AMT in the case
where ISOs are held at least for 1 year and a day after
exercise and 2 years and a day after grant. So it is somewhat
misleading for me to say there is no ordinary income tax in that
case. However, keep in mind that AMT does not apply to
everyone.

--
>
>
>
>
>
>
>
>
>
>

derkire · Joined: 10 Feb 2008 Posts: 6

Joeu2004,

First, I apologize again for not quite understanding this. I
have read the fairmark.com articles, and it did not ease my
confusion.

The only way I can understand your answer (and I thank you
again for providing it!) is if there is some sort of
terminology mismatch between you and I. Please read below.

> > If I dare summarize:
> > The implied gain (FMV-EV), if any, of an OPTION EXERCISE
> > is always recognized immediately as regular income.
>
> No. I think I was quite clear that that is not true in one case
> for ISOs (which are different from nonqualified employee stock
> options).
>

This I do not get. When I said OPTION EXERCISE, I meant the
action of turning the option into stock, with an unrealized
gain of FMV-OP(option price). I did not mean to include, in
any way, shape or form, the subsequent sale of the stock
(yet).

When you said "in one case for ISOs" in the quoted text
above, it appears to me that you were talking about the
holding period for the stock that you got from the ISO, and
not for the ISO itself.

Also, In your longer answer that I was trying to summarize,
you used the expression "For ISOs held at least 1 year and a
day after exercise". Again, I wouldn't hold ISOs after the
exercise, I would hold shares.

The terminology mismatch may be that when I said options
exercise, I REALLY meant only the exercise itself.

Now, I somehow, perhaps ignorantly or foolishly, still think
that it must be a correct statement that for an option
exercise, the gain=FMV-OP is always and immediately
recognized as ordinary income. It may be zero, but it is
still ordinary income.

Allow me to formulate the scenario in terms of 3 transaction
numbered 0-2 as follows:

date0: ISO grant date ,
gain0=0 (generally ISO grants are at OP=FMV)
date1: ISO exercise into shares,
gain1=FMV(date1)-OP
date2: Share sale ,
gain2=FMV(date2)-FMV(date1)

gain0: rarely anything but 0, because startups generally
grant ISO options OP=FMV. If gain0>0, treat as
ordinary income.

gain1: immediately recognized as ordinary income, can be
zero, and this occurs when FMV(date1)<=OP.

gain2: recognized as STCG/LTCG gain/loss, depending on
exercise dates, holding periods, 83(b) elections, and
whichever other rules may apply. Can be pos, neg or
zero. Applies also when date2=date1.

The "non-otherwise" section of your original answer
corresponds to date0 being 2y+1d ago, date1 being 1y+1d ago,
and date0 being today (day of sale).

For the case where date1 involved the direct disposition
(exchange) of the options for some other valuable/consideration
(cash, other options, what have you), rather than an exercise for
shares, the gain1 is again immediately recognized as ordinary
income.

How am I doing now? I'm really, really trying to understand
the logic behind and the practical consequences of the IRS
rules, and the above is the only way I can make sense of
it. The basic principles of the IRS seem to be as follows:

1. to recognize (and tax!) gains as early as possible, and
always using gain=FMV-CB(cost basis).

2. not to allow speculation (including option transactions)
to be treated as capital investments for preferential
tax purposes, except for the favorable treatment of ISOs,
and the 83(b) election loophole.

If you have given up on this tax amateur by now, I can
accept, but I'm honestly trying to understanding the
logic and simplify the description as much as possible, all
the while making it general enough that ut can be applied to
multiple different scenarios that may occur.

--
>
>
>
>
>
>
>
>
>
>

joeu2004 · Joined: 25 Aug 2007 Posts: 28

On Feb 15, 2:18 pm, derk...@gmail.com wrote:
> Also, In your longer answer that I was trying to summarize,
> you used the expression "For ISOs held at least 1 year and
> a day after exercise". Again, I wouldn't hold ISOs after the
> exercise, I would hold shares.

Yes, I got sloppy with my terms. But what possible meaning
could you give to the phrase "hold ISOs ... after exercise"?
There are no options per se to hold after you exercise them.
Anyway, perhaps I should have said: "hold shares resulting
from [or pursant to, in legalese] an ISO ... after exercise".

> > > If I dare summarize:
> > > The implied gain (FMV-EV), if any, of an OPTION EXERCISE
> > > is always recognized immediately as regular income.
> [....]
> When I said OPTION EXERCISE, I meant the action of
> turning the option into stock [...]. I did not mean to include,
> in any way, shape or form, the subsequent sale of the stock
> (yet).

And that is what I mean, as well. With ISOs (in contrast to
nonqualified employee stock options), there is no tax
consequence (except perhaps for AMT) when you exercise the
option; only when you sell (or otherwise dispose of) the shares
resulting from the option exercise.

> Now, I somehow, perhaps ignorantly or foolishly, still think
> that it must be a correct statement that for an option
> exercise, the gain=FMV-OP is always and immediately
> recognized as ordinary income. It may be zero, but it is
> still ordinary income.

Yes, that it is a foolish way of looking at it. In any case, you
said nothing [*] of allowing for zero "ordinary income" when
you wrote originally: "The implied gain (FMV-EV), if any, of
an OPTION EXERCISE is always recognized immediately as
regular income. Any further gain (or losses) on shares
subsequently held are long-or-short term capital gains,
depending on the holding period."

By your foolish way of looking at things, there is always
both(!) long-term and short-term capital gain; it is just that
at least one or the other is zero. (True, but nonsensical!)

[*] The only case you originally spoke of having zero ordinary
income was the special case of "share price == exercise
price".

> I have read the fairmark.com articles, and it did not ease my
> confusion.

I agree that Kaye Thomas's descriptions, while complete, can
be overwhelming. I tried to "cut to the chase". Obviously, I
am not helping you.

--
>
>
>
>
>
>
>
>
>
>

Zero Muni's - OID and Acquisition premium Comments? << << The Charter and the Guidelines for submitting >> << messages to this newsgroup are at >> <<

Calculating gain/loss after an acquisition I tried searching using what I thought were relevant keywords, but I haven't come across the answer to this scenario yet. It is about figuring out basis for stocks after one company acquires part of another. Let's say I bought 80 shares of GMH in Oct-19

Is this deductible acquisition indebtdebtedness? Taxable gai My brother, sister and I have a grantor trust with dad as trustee. My brother and sister live in homes owned by the trust- but that are understood by us to be "theirs", including increase in values- that have shot up in value over last few years, creating

401K funds frozen after merger/acquisition Our company was acquired by another company in year 2000. After that we were enrolled in the parent company's 401K plan. However the pre-existing 401K plan's fund had to be rolled over to the new plan. Every time we asked the old plan's administrator we

Taxable Event? Is this a taxable event? Had a business 5-10 years ago - when it ended I simply stored the scientific equipment since it could not be sold - even as junk. This last year I sold several batches at various prices from $300 to $800. The purchaser may send