All You Need To Know About IPOs, Going Public & Stock Options

Admit it. For weeks now, you’ve been dropping the terms “IPO” and “going public” and “stock options” in water cooler conversation and at cocktail parties and you don’t really know what they mean. Or how they make people rich. Or why it matters to you.

And it’s totally Facebook’s fault. As you know, Facebook is “going public” any day now and those “stock options” are going to make folks like Mark Zuckerberg and Eduardo Saverin ever more rich. As much as the whole world wants to pretend that we really don’t like those guys and we really hate Facebook (remarkable since 900 million of us are actually on Facebook), you can’t get away from the news.

So here’s what you need to know to feel smart.

An IPO is shorthand for initial public offering. It is exactly what it sounds like: the first sale of stock by a company to the general public, hence the clever shorthand “going public.” In most instances, an IPO is used to raise capital so that the company can get bigger. I’m not sure how much bigger Facebook can get but the offering is expected to raise as much as $14 billion, valuing the total compant (depending on final offering price) at anywhere from “$77 billion to $96 billion.

If you buy a share of a public company, the tax consequences are pretty straightforward. The price that you pay for a share of stock is generally your basis in the stock. Adjustments to basis happen when stocks split, merge or spin off – or through dividend reimbursements (for more on basis, see this prior post). When stocks are sold, there is a gain or loss between the selling price and the basis. The gain is considered capital gain and is taxed at rates between 0% and 35% for 2012, depending on your federal income tax bracket and the length of time that you held the stock (the rates are scheduled to change to between 8% and 39.6% in 2013). Capital losses reduce your capital gains.

But what if you don’t buy that stock on the market? What if you are given the right to buy the stock as a form of compensation? That right is called a stock option. Often, the right is to buy a share of stock at an agreed upon price that is less than fair market value of the stock.

There are usually two main reasons why a company would issue stock options:

  1. It’s cheap. It’s not the same as paying out cash so the company is able to give you the right to future growth in the company (assuming all goes well) without cleaning out their own accounts; and/or
  2. Stock options can be controlled. Companies can impose restrictions on transfers or schedule when the options “vest” (meaning when the shares are eligible to be purchased) based on length of time or other behaviors. This allows companies to lock in loyalty (sort of) to the company.

These reasons – lack of cash and urge to control – are why many employee stock options are initially offered to management, as part of an executive compensation package. As the company grows, options may also be offered to all employees who have worked at the company for a certain period of time.

There are two types of stock options: statutory stock options and nonstatutory stock options. Statutory stock options are the kind that you and I are most familiar with and are those granted as part of an incentive stock option (ISO) plan or as part of an employee stock purchase (ESP) plan. Nonstatutory stock options are the rest – or statutory stock options that are granted to non-employees (you can’t do that and retain the favorable tax treatment).

If you receive a statutory stock option, you generally don’t have any immediate tax consequences upon the grant or the exercise of the option (you exercise the option by buying a share of stock). You may, however, be subject to Alternative Minimum Tax (AMT) upon the exercise of an ISO – it can be one of those dreaded AMT triggers. The real tax consequences for most taxpayers, however, occurs when you sell the stock. At that point, you report the gain or loss just like you would by selling a share of Coca-Cola or General Electric.

If you receive a nonstatutory stock option, you might have tax consequences when you receive the option: it depends on whether the fair market value of the option can be readily determined. For some options (those that are traded on a market), that’s easy. But for newly established companies – or those that are just taking off – it can be nearly impossible to determine the fair market value of the option which is exactly what makes it so appealing. When that’s the case, there is no taxable event upon the grant of the option. There is, however, the realization of income when the option is exercised and again when the stock is eventually sold; it’s treated just like regular old stock at that time.

The exercise of an option generally involves paying cash for the shares of stock that you’re buying. But, realistically, those of us who aren’t Zuckerberg don’t always have that kind of cash. That’s why many employees take advantage of a so-called “cashless stock option purchase.” In a cashless purchase, a third party broker actually loans the money to buy the stock. You won’t realize this because it all happens in a flash – on the same day – and to you, it looks like one transaction. But what actually happens is that the third party broker loans you the money to exercise the options and then they sells some or all of the stock immediately using part of the proceeds to repay the loan. When this happens, the income triggered from the exercise of the option will be reported to you on your federal form W-2. If you had a capital gain or loss, this would be reported to you on a form 1099-B. Realistically, unless the stock is extremely volatile, you don’t have to worry about the form 1099-B: there won’t be a gain or loss because you’re buying and selling within a matter of hours or, quite possibly, minutes.

So there you go. All that you need to know about IPOs, going public and stock options to sound smart at the water cooler or cocktail party. If you need to know more or if you have special circumstances, check with your tax professional.

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