What is the tax treatment for stock options?
I sold my company (123) to XYZ for an upfront cash payment, installment payments based upon the attainment of financial forecasts and stock options. I assumed the deal was structured this way 1. to protect XYZ should 123 not be able produce as expected and 2. so that XYZ could meet 123's desired purchase price without having to put up all the funds. The stock options were issued to 123. The cash payment and installment payments were all treated as long term capital gains. The agreement for the stock options stated that it could not exercised until the sale or merger of XYZ (which they anticipated to occur in 3 - 5 years). If XYZ was to be sold, the stock options could be exercised and then immediately sold to XYZ or to the acquiring company. It appears that XYZ is about to be sold. I am getting conflicting information on the tax treatment. XYZ says that I have to treat the proceeds from the sale as income as part of their employee incentive plan. But then indicated is would be short term capital gain as the holding period of the stock will be a matter of days. The options were issued to 123. 123 is not and never was an employee or subcontractor for XYZ. A tax advisor said that it is should be long term capital gains since the options were part of the original purchase agreement between 123 and XYZ and the options should be considered as a final installment payment. Also, given that XYZ was an LLC it probably didn't actually have stock only equity positions. The IRS kept talking about recapitalization. As such the holding period would extend to the date that the option was agreed. I guess whether it can be a recapitalization depends on whether the stock is bought back by XYZ or bought by the acquiring company????? Any assistance will be greatly appreciated.
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Tax Professional Answers
Bill Robinson, CPA
You state that XYZ is an LLC. An LLC is either taxed as a disregarded entity, a partnership or an association taxable as a corporation. So maybe XYZ had stock and maybe it did not. If stock options were issued then the LLC I will assume is treated as an association taxable as a corporation. If options were issued it sounds like the options were restricted upon the happening of a specific event - the sale of XYZ. The event was not guaranteed to occur. The value of the options at the date of grant was indeterminable (there was no market for the options). I am not sure how the options are part of the XYZ employee incentive plan unless they were issued to the you as the owner in exchange for services (then you should have explored an IRC Sec 83(b) election at the time of grant). Assuming that is not the case, there are two questions - 1) What is the holding period and 2) is it capital gain or ordinary income. You mention the IRS so maybe a third consideration is whether the IRS has challenged the arrangement and what is the IRS position and is it advantageous to you? I would argue that the holding period begins the date the option is exercised because the stock is inherently a different asset than the option. Stock is a capital asset. So you probably have ST Cap Gain treatment. Now the IRS may be arguing that the LLC by issuing options defaulted into an association taxed as a corporation and XYZ granting employee options further validates that position. So perhaps that is where the recapitalization argument is coming from?? I think to say the options are a final installment payment is a stretch. May guess is you have ST Cap Gain. This question turns on a detailed analysis of the facts and some tax research applied to those facts. Good luckLeave a Comment 351 weeks ago