Using a Stock Swap to Maximize Clients’ Compensation

In this scenario, Jack would end up with 400 shares of ABC—100 shares with a carryover basis of $10 per share and 300 shares with a basis of $100 per share. The shares used in the swap maintain their original basis and holding period. The other 300 shares have a basis of $100 because, upon exercising the NQSO grant, Jack must pay ordinary income tax on the difference between the grant price of $25 and the fair market value of $100. The income tax payment on the $30,000 proceeds sets the basis on the nonswapped shares at $100 per share. 

Improving the Strategy With an ISO

Now, let's look at the same scenario, but this time, Jack has an ISO grant instead of an NQSO.

Thanks to the ISO's unique statutory tax treatment, when Jack swaps 100 shares as payment for the ISO exercise, he doesn't have to pay ordinary income tax. Following the swap of his 100 shares, Jack will own 400 shares of ABC. As in the previous example, 100 shares will have a carryover basis of $10 per share. Unlike the NQSO swap, however, the ISO swap will result in a basis of $0 per share for the remaining 300 shares. 

Remember These Caveats

Keep in mind that for the client to reap the long-term tax benefits of an ISO, holding period requirements must be met. When swapping stock to exercise an ISO grant, the client must be mindful not to use shares acquired through an earlier exercise that have not met the holding requirements; otherwise, the swap will result in a disqualifying disposition subject to ordinary income tax. To avoid a disqualifying disposition, be sure that the shares to be swapped have been held at least two years from the date of the grant and one year after exercise. 

Another potential issue when exercising ISOs is the possibility of triggering alternative minimum tax exposure. It's essential to work in tandem with your client's CPA when considering the exercise of any stock option.

That said, for many clients who receive grants of company stock, the stock swap strategy can be an effective, tax-efficient way to maximize their compensation.