The ongoing bull run in the equities market has generated significant wealth for many clients, particularly those who receive stock grants and options as part of their compensation.

In the current environment, executives of publicly traded firms who receive much of their pay in the form of company equity are seeking ways to maximize their wealth in a tax-efficient manner while addressing the risks inherent in owning a concentrated position.

To help these clients achieve their goals, advisors need to understand their clients’ compensation packages and the planning strategies available to unlock their value.

One tactic that may benefit some clients is swapping currently owned employer shares as a tax-efficient payment for exercising a nonqualified stock option (NQSO) or incentive stock option (ISO) grant. 

To illustrate the benefits of a stock swap, let’s look at an example:

Jack Smith owns 100 shares of ABC, his employer, with a tax basis of $10 per share and a current fair market value of $100 per share.

Jack also has a vested NQSO grant allowing him to buy 400 shares of ABC at a price of $25 per share.

Jack doesn’t have the $10,000 he’d need to exercise the option grant. Rather than selling the 100 shares he owns to generate the cash, Jack can deliver those shares as payment. The benefit here is that he doesn’t have to pay the $90-per-share capital gain he would have otherwise incurred if he had sold the shares versus swapping. 

In this scenario, Jack would end up with 400 shares of ABC—100 shares with a carryover basis of $10 per share and 300 shares with a basis of $100 per share. The shares used in the swap maintain their original basis and holding period. The other 300 shares have a basis of $100 because, upon exercising the NQSO grant, Jack must pay ordinary income tax on the difference between the grant price of $25 and the fair market value of $100. The income tax payment on the $30,000 proceeds sets the basis on the nonswapped shares at $100 per share. 

Improving the Strategy With an ISO

Now, let’s look at the same scenario, but this time, Jack has an ISO grant instead of an NQSO.

Thanks to the ISO’s unique statutory tax treatment, when Jack swaps 100 shares as payment for the ISO exercise, he doesn’t have to pay ordinary income tax. Following the swap of his 100 shares, Jack will own 400 shares of ABC. As in the previous example, 100 shares will have a carryover basis of $10 per share. Unlike the NQSO swap, however, the ISO swap will result in a basis of $0 per share for the remaining 300 shares. 

Remember These Caveats

Keep in mind that for the client to reap the long-term tax benefits of an ISO, holding period requirements must be met. When swapping stock to exercise an ISO grant, the client must be mindful not to use shares acquired through an earlier exercise that have not met the holding requirements; otherwise, the swap will result in a disqualifying disposition subject to ordinary income tax. To avoid a disqualifying disposition, be sure that the shares to be swapped have been held at least two years from the date of the grant and one year after exercise. 

Another potential issue when exercising ISOs is the possibility of triggering alternative minimum tax exposure. It’s essential to work in tandem with your client’s CPA when considering the exercise of any stock option.

That said, for many clients who receive grants of company stock, the stock swap strategy can be an effective, tax-efficient way to maximize their compensation.