Black Investors: Are You Sure You Don't Owe Taxes On Your Stock Options?

If you have received stock options in the last few years, this editorial is especially for you. We have begun to hear rumblings from our investing friends that they are not quite sure how much tax they owe on capital gains and on their stock options. Some have left this important work to their trusted financial advisors and accountants and others have yet to figure their taxes at this late date. That is no surprise, but a surprise or two may be awaiting those who have exercised stock options and who have attempted to wait a year before coughing up taxes to the IRS.

We recently sent out an advisory regarding this issue to a private group of investors, journalists, members of Congress and their staffs, economists and hedge fund managers. Here is what we sent:

Black Electorate Communications

Black Economic Watch: The Black Investing Class' Stock Options Tax Nightmare

March 20, 2001

In the next couple of weeks don't be surprised to hear stories from some members of the Black middle and professional class regarding some unexpectedly large tax bills. Of course, waiting until the last minute to pay taxes is nothing new for many but this year may be unusual in that more people than ever, in Black America, are involved in the stock market. We have heard numbers indicating that as few as 15% and as many as 50% of Black households have at least one member who is invested in the stock market. Although we tend to believe the smaller number, we are quite sure that more Blacks were involved in the equities market in the year 2000 than in any other year in the history of Wall St.

And besides that we are confident that a disproportionate amount of the estimated 10 million Americans who are said to have been given stock options are Blacks - either laborers with Employee Stock Ownership Programs (ESOPs), professional investors involved in a variety of ventures and career professionals who were wooed to new dot com and start-up companies with visions of becoming paper millionaires.

It is clear that most of those in the above categories were familiar with the upside of stock options. It is becoming increasingly obvious, from the stories that we are hearing and the accounts that we are reading, that the same individuals were not prepared, at all, for the downside.

The problem, in short, is that of late, the stock market has not cooperated according to the visions of those seeking paper riches. And because of this market slide; ignorance of the stock market; and poor advice; stock options which were once an investment dream are now becoming a taxpayer's nightmare.

Why?

Primarily because many investors don't realize that once they have exercised their stock options, even if they do not sell their stock holdings, they are still liable for paying taxes. And once the stock is sold, if the stock has appreciated in value, they are responsible for paying capital gains taxes on the difference.

In order to understand this it is important to understand that there are two types of stock options: incentive and non-qualified.

The most common type of stock options are non-qualified stock options, which are frequently awarded to employees at all levels. The second type, incentive stock options, are more often given to senior managers but an increasing number were given this past year to those employees in the high-tech world.

The two types of stock options are taxed in different ways. Incentive stock options are not subject to regular income tax when they are exercised. Non-qualified stock options are subject to the standard income tax. However, incentive stock options are tricky because while one who exercises them is not automatically subject to normal income tax, they may find themselves subject to the Alternative Minimum Tax (AMT). And Alternative taxable income is a separate income tax calculation that includes certain items that the regular income tax calculation does not include.

One of those items that is included in alternative taxable income and not in regular taxable income is the difference between the market price of stock and the option price of stock on the day the option is exercised. For example, today you exercised 3,000 options that were granted to you through the company's incentive stock option plan. The option price was $1.75 per share (and so you wrote the company a check for $5,250). The market price today was $31.75 per share. You have no additional taxable income for regular tax purposes. You DO however have $90,000 of additional taxable income for alternative minimum tax purposes.

And because one can get a favorable capital gains tax rate if they sell the stock a year after exercising the incentive options, many people do hold on to stocks, without selling them, for an entire year - just to qualify for the lower rate. However, the stock price does not always cooperate with this plan and quite often falls below the price that it was at when the stock option was exercised. This means that the capital gains that one achieved after exercising the option may evaporate entirely - as has been the case many times over this year. And it even means that you may take a loss in total.

Most importantly a person in this scenario would find that they have no capital gain to show, but that they STILL owe taxes from the exercising of their incentive options.

It would have been possible to avoid this if, after a person exercises their options, they then immediately sell the stock before 1 year.

The LA Times recently wrote of such a scenario:

"Shares purchased with employee stock options must be held at least a year to qualify for favorable long-term capital gains treatment. Qualifying for capital gains rates can be a big boon when stock prices are stable or rising. But sometimes it can make sense to bail out early on your shares, particularly if the shares were purchased using incentive stock options and if the tax bite will be less than under the AMT system. Here's an example, courtesy of CPA Goodfriend. Suppose you bought stock using your incentive stock options for $1 a share when the fair market value was $101 a share. Since then, the share price has plunged to $40. Under the alternative minimum tax, you could owe up to 28% federal tax and 7% California state tax this year on the $100 difference between what you paid and what the stock was worth at the time--an alternative minimum tax of about $35 per share. But if you sell the stock now, before the one-year holding period is up, you would pay ordinary income tax based on the difference between the price you paid and the price you get when you sell. Even in the top state and federal tax brackets, the tax would be about $18 per share."

In the case of non-qualified stock, a person can exercise their options, then immediately sell the stock. This would limit their taxes to the difference between the exercise price and the market value. But what if you exercise your option and keep your shares? You'll still owe taxes on the difference between the price at which the options were granted and the stock price on the day you exercised the option. And if the price of the shares continues to rise, you'll be taxed again when you sell, this time on the difference between the price on the day you exercised your option and the price on the day you sell your shares.

As an example, if you exercise an option to buy 1,000 shares for $5 a share and sell them a year later for $10 a share, you'll owe capital gains taxes on $5,000. That's on top of the income tax applied to the difference between your option price and the market price of the stock when you exercised the option.

With either incentive or non-qualified stocks, a person can show enormous gains on paper after exercising the options and if they do not sell the stocks right away and the stock falls, they can find themselves with absolutely no gains and yet still liable for a tax on the difference between the strike price of the stock options and the market price of the stock on that same day.

The problem is that many people are looking for the stock to continue to rise or maintain its price level in order to pay for new goods and services, of course, but also to pay bills and even their taxes.

That's if they even know what they own.

According to an Oppenheimer survey, 34% of workers are ignorant of what type of options they own and up to 75% are unaware of how the AMT kicks in with incentive stocks.

Of course the numbers are even higher with Blacks who are largely getting involved in the stock market for the first time.

We expect that probably 25 to 40% of those Blacks who owe taxes on options are unaware of their tax burdens. And their response will not be pretty.

Once one is hit at the last minute with a bill like this, just weeks before the April 15th tax deadline, their options are limited. They will either have to take money out of their savings, borrow money to pay the bill, work out payment arrangements with the IRS or sell more stock in order to get the cash necessary for the taxes that they owe.

It was this latter option, selling more stock, that rocked the financial markets last year, right before the April 15th deadline according to economist Jude Wanniski of Polyconomics.com

We wrote about this last year at BlackElectorate.com

The column is from April 17, 2000, "Explaining The Crash: Did The Financial Media Miss Something?"

If history repeats itself this April it will definitely have a Black face to it...

Cedric Muhammad

Monday, April 2, 2001

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The views and opinions expressed herein by the author do not necessarily represent the opinions or position of BlackElectorate.com or Black Electorate Communications.