early exercise ISO, then sell it back at grant price

Technical topics regarding tax preparation.
#1
Keyad22  
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Hi everyone,

Would like some help for the following issue.

Taxpayer did early exercise ISO of company A: grant price $1 and exercise price $6. He made 83(b) election. In 2 months, he moved to a new company, company B. He had to sell the ISO back to the company A at grant price $1 based on the agreement. What tax consequence for him?

Is it a DD? If it is a DD, $5 will be on his W-2 income. His basis on the ISO is $6, and he has $5 capital loss.

Is my analysis correct?

Taxpayer wants to know why there would be any tax for him since her actually gets nothing. He purchase the ISO at grant price and sold it back at the grant price.

Thank you!
 

#2
makbo  
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I think you mis-used the term "exercise price", I think you meant FMV.

Yes, it is a disqualifying disposition (what I think you meant by "DD").

Your analysis is not correct, there are well-known risks to making an 83(b) election for early exercise ISOs, unless full price (FMV) is paid. Specifically, he does not get a capital loss deduction.

§83(b) states in part "If such election is made, subsection (a) shall not apply with respect to the transfer of such property, and if such property is subsequently forfeited, no deduction shall be allowed in respect of such forfeiture."
 

#3
Keyad22  
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Hi Makbo,

Yes. I mean FMV.

Forfeited is give up. Is selling back to company B at grant price a forfeited action? It is huge tax liability when there are hundreds thousands shares of ISO involved. Please confirm. Thank you so much!
 

#4
makbo  
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I'll wait until others come along to comment. See also example 6 in Rev. Proc. 2012-29.
 

#5
makbo  
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Keyad22 wrote:Taxpayer wants to know why there would be any tax for him since her actually gets nothing.

I just thought of the answer to this question, so I guess I'm not waiting after all.

The reason there is tax is because Incentive Stock Options are designed to give an INCENTIVE to the worker to remain with the company for an extended period of time, in the form of favorable tax treatment. It's carrot-and-stick: if you follow through on the incentive correctly, you get the sweet capital gains tax rate; if not, you get ordinary compensation income. And if you make an even bigger gamble by electing to recognize, as income, the transfer of stock that you aren't even vested in yet, then the stick portion of carrot-and-stick is bigger, too.
 

#6
Nilodop  
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KPMG discusses disqualfying dispositions thusly:
Disqualifying Dispositions
To receive favorable tax treatment of ISOs, employees must meet the ISO holding period requirements described above. If an employee disposes of those shares before the end of the ISO holding period, the employee in most cases has made a disqualifying disposition. Such a disposition results in an increase in the employee’s income and a deduction for the employer in the tax year during which the disposition occurs. The increase and deduction are generally based on the spread at the time of exercise.10 However, if the stock is sold at a price less than the stock FMV on the date of exercise, the amount of compensation income is limited to the excess of the amount realized on the sale over the exercise price.11
. Here's the referenced note 11.
11 Sections 422(c)(2), 1.422-1(b)(2)(i).
Here's the KPMG memo. https://home.kpmg/content/dam/kpmg/pdf/ ... 2-2016.pdf

As always, it's best to read the authorities, but I think KPMG has it right.

Generally, section 83 has no relevance to ISOs. But, also as discussed by KPMG, it does for AMT purposes, which has not been addressed yet in this thread.
 

#7
makbo  
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Nilodop wrote:Generally, section 83 has no relevance to ISOs.

That's not a true statement. 83(b) does not apply most of the time because the shares are usually vested at time of exercise, but in this case it was an early exercise and the shares were not vested, so 83(b) very much has relevance. If the employee had stuck with the job and the company had increased in value, it would have been a very smart move. But as noted, not one without risks.

It was not a sale, it was a forfeiture. The employee had no choice in the matter, either as to timing or price. Did you read the example in the rev proc that I referred to? Your KPMG excerpt does not address this situation at all. I have consulted two independent resources on this matter, including a book by Kaye Thomas (Fairmark.com) which is all about equity compensation, and they both say the same thing I am saying.

[edit: see my post #10]
Last edited by makbo on 24-Apr-2019 10:25am, edited 2 times in total.
 

#8
makbo  
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Keyad22 wrote:Forfeited is give up. Is selling back to company B at grant price a forfeited action?

You are falsely assuming that a forfeiture must mean $0. Not so; the original payment can be transferred back even as the property is forfeited. Remember, the shares were not vested, which is the only time 83(b) election makes sense.

As previously stated, it was not a "sale" back to the company. It was imposed on him because the shares were not yet fully his to control.

As §83(c) puts it,

"(1) Substantial risk of forfeiture

The rights of a person in property are subject to a substantial risk of forfeiture if such person's rights to full enjoyment of such property are conditioned upon the future performance of substantial services by any individual."
 

#9
Keyad22  
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Got it. Thank you!

If the 83(b) election was not made for the early exercise, will there be any difference?
 

#10
makbo  
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After more reading and thinking about this, I'm backing off somewhat from my original conclusion and am open to a better, more authoritative explanation. It may be after all that the 83(b) election has no effect for regular tax purposes on early exercise of ISOs, only for AMT purposes (where preference adjustment would not normally be made until shares vested). But if this is true, I do not understand why not. 83(b) seems pretty clear, and it gives no exception for ISOs. Why would the election to recognize compensation income at time of transfer of property not apply? Then, the subsequent disposition wouldn't matter as far as compensation was concerned.

Keyad22, is this a 2018 event, or are you just trying to plan for 2019? IOW, has the employer actually issued a W-2 showing the compensation income as you describe? It would be nice to know what they think is the correct treatment, so you can see what you are dealing with.
 

#11
makbo  
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§422(b) says, "[The term "incentive stock option"] shall not include any option if an election is made under section 83(i) with respect to the stock received in connection with the exercise of such option."

I've read 83(i) several times now and still can't even figure out what election it refers to.

So there is some kind of connection between the two code sections, but what it is exactly I can't say right now.
 

#12
Keyad22  
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It happened in 2019.

I saw the print screen for the early exercise of ISO. The website asked them "You are qualified to make 83(b) election. Would you like to make?" something like that.

Taxpayer just checked "Yes" and that website will automatically generate the form.

He did early exercise on NSO in 2019 as well and filed 83(b) election to IRS.
 

#13
Keyad22  
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If taxpayer made early exercise on ISO and did not make 83(b) election. The ISO, not vested, sold back to prior company at grant price. Will there be any AMT preference since the ISO is not fully vested?
 

#14
makbo  
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AMT preference adjustment absent an 83(b) election only happens when the stock is vested.
 


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