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A stock option gives an employee the right to buy tock at a specific price within a specific time period Stock options come in two varieties: the incentive stock option (ISO) and the nonqualified stock option (NSO) Incentive stock options are not taxable to the employee at the time they are granted nor at the time when the employee eventually exercises the option to buy stock If the employee does not dispose of the stock within two years of the date of the option grant or within one year of the date when the option is exercised, then any resulting gain will be taxed as a long-term capital gain However, if the employee sells the stock within one year of the exercise date, then any gain is taxed as ordinary income An ISO plan typically requires an employee to exercise any vested stock options within 90 days of that person s voluntary or involuntary termination of employment The reduced tax impact associated with waiting until two years have passed from the date of option grant presents a risk to the employee that the value of the related stock will decline in the interim, thereby offsetting the reduced long-term capital gain tax rate achieved at the end of this period To mitigate the potential loss in stock value, one can make a Section 83(b) election to recognize taxable income on the purchase price of the stock within thirty days following the date when an option is exercised and withhold taxes at the ordinary income tax rate at that time The employee will not recognize any additional income with respect to the purchased shares until they are sold or otherwise transferred in a taxable transaction, and the additional gain recognized at that time will be taxed at the longterm capital gains rate It is reasonable to make the Section 83(b) election if the amount of income reported at the time of the election is small and the potential price growth of the stock is significant On the other hand, it is not reasonable to take the election if there is a combination of high reportable income at the time of election (resulting in a large tax payment) and a minimal chance of growth in the stock price, or that the company can forfeit the options The Section 83(b) election is not available to holders of options under an NSO plan The alternative minimum tax (AMT) must also be considered when dealing with an ISO plan In essence, the AMT requires that an employee pay tax on the difference between the exercise price and the stock price at the time when an option is exercised, even if the stock is not sold at that time This can result in a severe cash shortfall for the employee, who may only be able to pay the related taxes by selling the stock This is a particular problem if the value of the shares subsequently drops, since there is now no source of high-priced stock that can be converted into cash in order to pay the required taxes This problem arises frequently in cases where a company has just gone public, but employees are restricted from selling their shares for some time after the IPO date, and run the risk of losing stock value during that interval Establishing the amount of the gain reportable.



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