So, your company is being sold and you want to know whether you should exercise your stock options prior to closing.
First you should confirm whether the transaction agreement (i.e., stock purchase agreement, asset purchase agreement, or merger agreement) provides that vested unexercised stock options will be cancelled at closing in exchange for the same consideration a stockholder would receive, minus the exercise price. If it does, and if you hold nonstatutory stock options (NSOs) then you needn’t, and really shouldn’t, exercise. You’ll be paid out your fair share by holding your NSOs through closing. Any proceeds received in respect of your NSOs will be ordinary income taxed as the money is received the same way you would be taxed on a cash bonus.
Whether the holder of an incentive stock option (ISO) should exercise is a little more complicated.
No employment tax is due on an ISO exercise, but employment tax will be owed if the ISO is held until closing and cashed-out. So, you would avoid paying some social security and Medicare tax by exercising an ISO pre-closing. For this strategy to work the exercise should not be contingent on closing and should occur at least 3 business days prior to closing (rule of thumb).
However, if the deal has significant contingent consideration, the employment tax savings, may not be worth it.
We are dealing with the interplay between two different tax rules: One rule (I’ll call this the “Option Exercise Rule”) says that when an ISO is exercised and the stock is sold soon after for cash, the employee is taxed on the difference between the exercise price and the fair market value of the underlying stock on the date of the option exercise. The other rule (I’ll call this the “Installment Sale Rule”) generally allows sellers of stock to defer tax on payments received in years after the year of closing.
Which of these rules trumps when an employee exercises just before the acquisition? And if the Option Exercise Rule trumps, how are the escrow or earnout dollars counted in determining the employee’s tax?
The tax law and the IRS have never answered these questions, and reasonable tax advisors may differ. But I believe that the Option Exercise Rule trumps and that the tax law thus requires that optionees be taxed in the year of the option exercise on the escrowed dollars and on any earnout or other contingent consideration discounted for risk and the time value of money.
This means by exercising your ISO you may end up being taxed in the year of closing on dollars that won’t be received until a future year and might never be received. So where the transaction agreement provides that vested unexercised stock options will be cancelled at closing in exchange for the same consideration a stockholder would receive, minus the exercise price, I would not exercise an ISO unless the employment tax savings are worth more to you than the risk of accelerated tax on contingent proceeds.
And keep in mind – generally buyer/buyer’s accountants will be in control of how this is reported, since they often control the W-2s for the year of the sale. So, before exercising an ISO prior to closing I would try to find out how buyer intends to treat such exercises.
Mike Baker frequently advises with respect to stock options. He possesses a breadth and depth of experience in tax and employee benefits & compensation law that spans multiple decades. For additional information, please contact mike@mbakertaxlaw.com.