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Author: KATinChicagoland Three stars, 500 posts Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 121216  
Subject: Re: stock option exercise with stock Date: 12/13/1997 8:50 PM
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<<I have been told that there is a tax advantage to exercising stock options by buying them with appreciated company stock. If so, what's the advantage and whats the tax basis for the newly acquired stock??
>>

The advantage is you get tax-free exchange treatment on the shares you surrender--unless you are surrendering ISO shares that have not met the holding period requirement, to acquire more ISO shares. ("ISO" stands for incentive stock option.)

Here's an example. You hold 100 shares of XYZ (your employer), basis $40 and value $75. You also hold an option (not an ISO) to acquire 150 shares of XYZ at $50. One way to exercise the option is to come up with $7,500 in cash. When you do this, you will pay tax on the difference between the fair market value and the exercise price, or $3,750 (150 * $75 - $7,500).

Instead, you turn in $7,500 worth of stock. (You can only do this if your option, or the plan under which it was issued, permits this.) You are turning in 100 shares, and receiving 150, for a net increase of 50 shares. You still pay tax on $3,750. And you end up with two groups of shares with different basis: 100 shares with a basis of $40 each (which is what you stared with), and 50 shares with a basis of $75 each (which matches the $3,750 of income you paid tax on).

This is generally a better result than if you sold the original 100 shares to raise the $7,500 exercise price on the new 150 shares, because then you would pay tax on the gain from that sale in addition to paying tax on $3,750 income from exercising the option. But if you have $7,500 available without selling your old stock, there really isn't a tax advantage in this approach. At that point, it's just a matter of your choice of whether you want to increase your stock holding by 50 shares (turn in the 100 for 150) or by 150 (keep the 100 and use cash to exercise the option).

If you're dealing with incentive stock options you may be able to do the same thing but there are some special rules you need to be aware of.

Feel free to request more details.

KAT in Chicagoland
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