The end result of a stock swap is often that you control fewer shares post-swap then you did pre-swap. Prior to the stock swap, you had owned 10, long-only shares and the option to purchase 5, shares from the ESO. After the stock swap, you have 9, long-only shares and 5, newly acquired shares from the exercise and hold of the ESO. Because of this reduction in total shares controlled, a stock swap is one way to limit or decrease your concentrated equity position. To evaluate whether a stock swap is a good idea or a bad idea, it makes sense to compare it to other exercise strategies. Two common strategies are a cash exercise and a cashless exercise.
A cash exercise may be a preferable strategy to stock swap if you are bullish on your company stock and want to retain as many shares as possible. With a cash exercise, you retain more shares post-exercise than you do with a stock swap. Since you paid cash, you will retain the 10, long-only shares you own and pick up an additional 5, shares from the ESO, for a total of 15, shares.
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This is 1, shares more than the swap stock in our example. The second option is a cashless exercise. If you are not bullish on your company stock or want to diversify your concentrated position, a cashless exercise may be a better strategy for you. In a cashless exercise, you use shares acquired via the exercise itself to cover the cost of the exercise.
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Since you sold 1, of your ESO to cover the cost, you retain the remaining 4, Post cashless exercise, you own 10, previously owned shares and 4, shares from the exercise and hold, for a total of 14, shares. Both the stock swap scenario and the cashless exercise scenario, you retain 14, shares. The post-exercise share control is identical.
This difference is important as we evaluate the tax impact if the employee stock options are non-qualified or incentive stock options. When you use long-only stock to exercise non-qualified stock options NQSO via a stock swap, the swapped shares retain their original cost basis and acquisition date through the exercise. Swapping shares is generally a non-taxable event.
However, the exercise itself is a taxable event subject to normal NQSO tax rules.
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This means that the bargain element of your exercised non-qualified stock options is subject to ordinary income, Medicare, and Social Security tax, if applicable. You pay income tax regardless of how you pay for the exercise cost of your NQSO. You have also acquired 5, newly owned shares from the exercise of the NQSO. You can use long-only stock to exercise incentive stock options, too. Like NQSOs, the tax rules regarding an exercise of incentive stock options, or ISOs, are the same whether you exercise via a stock swap or via another method.
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This means that when you exercise and hold ISOs, the bargain element will be a tax preference item for calculating the alternative minimum tax , assuming you exercise and hold the shares past the calendar year-end. It also means that exercised ISOs equal to the number of shares swapped will retain the cost basis of the original shares.
However, the newly acquired shares via the exercise will likely have a basis equal to zero. If you exercise and hold ISOs in an attempt to achieve a qualifying disposition hold the shares past year-end , you do not claim ordinary income in the year of exercise. Instead, the bargain element is a tax preference item for calculating the AMT.
Since the bargain element not claimed as ordinary income, it has no adjustment to that cost basis of the new shares.
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These two are the same as what we saw in the example with NQSOs. This is because the entire bargain element is taxed when calculating the AMT. The above illustrations cover what a stock swap may look like if you own long-only shares and use those shares for the swap. Typically, long-only shares are shares you purchased on the open market, acquired when your restricted stock units vested or obtained when you exercised non-qualified stock options.
The shares types above typically have a single cost basis that makes them look similar in terms of how they can be used to exercise your employee stock options and what the tax implications may be. You can also use shares acquired from an employee stock purchase plan or from an exercise and hold of other incentive stock options grants to do a stock swap. However, the rules and taxability of which may become significantly more complicated. This is because these shares often have different tax rules subject to holding period requirements. These requirements and subsequent tax rules can make using shares received through an ESPP and ISOs in a stock swap more complicated than other methods.
A stock swap can be a useful strategy that allows you to do a tax-free swap of shares you own for employee stock option shares. Cashing out tends to be the preferred route for all parties involved. The surviving company avoids the complex challenges of taxes and administration -- not to mention the stock issuance procedure -- and the employees get a tidy little lump sum payout. The surviving company may also assume the stock options in order to avoid creating a drop in equity, or it may substitute its own stock options for those of the acquired company to maintain uniformity.
Again, these decisions are made on a case by case basis. The choice often depends on whether the surviving company is a public corporation and what action will be more fiscally prudent under federal statutory tax law.
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Emma Cale has been writing professionally since Stock Options. By Emma Cale. Accelerated Vesting Accelerated vesting often occurs during a change of control event such as a merger, when your company is acquired by another or when it goes public. Cancellation In some cases, a merger between two entities will result in the cancellation of the stock options. Cash Buyout Unexercised stock options may also be cashed out during the merger by the surviving company or by the acquiring company. Assuming or Substituting Stock Options The surviving company may also assume the stock options in order to avoid creating a drop in equity, or it may substitute its own stock options for those of the acquired company to maintain uniformity.