Another Investment tax saving strategy involves the handling of employee stock option. The grant of a nonqualified stock option results in no compensation to you as an employee. But exercising your option does result in compensation, measured by the difference between the option price and the fair market value at the time of the exercise.
Example: The grant of an option to buy 1,000 shares at $20 per share when the market value is $25 per share result in no income to you. If you exercise the option later when the market value is $40, you will recognize compensation income of $20,000. This taxable income plus the cash investment necessary to exercise the option are the major disadvantages of nonqualified stock options. In order to exercise the option in the above example, you must raise $26,000 in cash; $20,000 to buy the stock, and as much as $6,000 to pay the tax in the 30% bracket.
Nevertheless, the Internal Revenue Service Revenue Rule 80-244 open an opportunity to a tax saving strategy at the exercise moment when it allows that if full or partial payment for stock acquired upon exercise of a nonqualified stock option is made by transferring identical shares in the employer company, it will not result in any gain to you on the shares used to pay for the stock option, the following example will show how to take advantage of this ruling:
Example: Assume you already owned 1,000 shares of stock of your employer acquired at $10 per share. Later you are allowed to exercise and acquire 2,000 additional shares of identical stock at an option price of $25 per share ($50,000 total). At the time of exercise, the market value of the stock is $50 per share ($100,000 total value). If your employer agrees, you can pay for the 2,000 new shares by transferring to that employer the 1,000 shares of identical stock you already owed. Since the value of the stock surrendered equals the option price, no cash is needed to buy the stock. I this way you defer recognition of gain on the transfer of the 1,000 old shares, but you enjoy the full appreciated value by converting 1,000 shares of stock into 2,000 shares. This technique reduce the required cash to $15,000 as been this the necessary amount to pay the tax on the $50,000 of compensation in a 30% Federal and State bracket. Of Course, a proportionate reduction in the number of shares or the value of the shares would result in a proportionate reduction in the amount of cash that you actually would like to lay out.