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Know Thy Options And Save A Bundle

By Allan Ratafia, CPA, MS

Many publicly traded companies like to take advantage of the growth in their stock by granting stock options to rank-and-file employees along with executives. However, while stock options may be a vehicle to fortunes, those fortunes are often dramatically reduced, if not entirely lost, due to poor understanding by the option holder (the employee).

Option holders are part of a unique paper society. Regrettably, this paper is not cash. Transitioning from a "paper society" to the "cash variety" has startling tax consequences, which often leaves the option holder frustrated and aggrieved. Many option holders are unaware how best to exercise their options. In turn, they overpay their taxes without ever knowing it. Stock options represent a significant untaxed asset. Proper planning for this eventual tax will save the option holder a bundle.

Option Basics:

The First Commandment for the option holder is "Know Thy Options." There are two types of employee stock options - Nonqualified Stock Options (NQSO’s) and Incentive Stock Options (ISO’s). Too often people are not aware exactly which type of options they have. The following explanation will help simplify and clarify the differences between the two.

The big difference is that NQSO’s may be hit with a whopping double tax compared to ISO’s. NQSO’s are usually taxed at the highest federal rate(around 40%) while ISO’s can be taxed as low as half.

The high tax of the NQSO makes it essentially a traditional annual bonus, only the employee determines when the bonus will be paid. NQSO’s are taxed when exercised on the gain between the stock value less the strike price. Just like a regular bonus, this is treated as compensation and will be subject to appropriate tax withholdings and will be included on the employee’s W2 form. This is true regardless if the employee sells or holds the underlying stock after it is exercised.

ISO’s are another game all together. They offer much greater tax benefits to the option holder than NQSO’s. Rather than being taxed when exercised, they are taxed when the option holder sells the underlying stock. If the stock is sold after holding it one year from exercise, the entire gain is treated as long-term capital gain and is subject to the preferential lower rate. If the shares are sold within one year, it is treated as a disqualifying disposition and the gain will be included on the employees W2 as and taxed at the higher rate.

Caveat to the option holder: When an ISO is exercised and held, although there is no federal income tax at exercise date, the paper gain at that time is subject to the alternative minimum tax (AMT). What many option holders don’t recognize is that the AMT is merely a prepayment of tax, which will be credited back by the IRS. The AMT is often the ticket to the low tax rate, so don’t be afraid of it.

Things To Look Out For:

Option holders are often surprised, when reviewing their options account, to discover that they have both types, even though they may have been issued only ISO’s. If more than $100,000 of ISO’s vest in one year, the excess automatically become NQSO’s. Employees of companies with a high share price value can quickly reach this $100,000 level. An unsuspecting employee who anticipates all his options to be ISO’s may be surprised to learn that the bulk of the grant went to NQSO’s.

Another item to look out for is a mistaken disqualifying disposition of an ISO. Even if the ISO was appropriately held for one year after exercise, it could be taxed at the higher rate. In order to receive the low tax rate, the option holder must not sell the option within two years from the date of grant. For example, if an option is granted on January 1st this year, the earliest it can be sold is January 2nd two years later. If these options have accelerated vesting on say June 1st this year, and the option holder exercises them at that time, he must wait until January 2nd year two to sell (eighteen months later), not the normal twelve months. The option holder may think it’s okay to sell it on June 2nd next year after holding it for one year, when in fact this would disqualify the sale and tax the gain at the higher level.

Understanding When, How And Which Options To Exercise:

The general rule is, exercise and hold ISO’s when the stock price is low and exercise and sell NQSO’s when the price is high. During a recent market correction, I emailed my clients mentioning that if you still believe in your company, this would be a good time to exercise your ISO’s, not your NQSO’s. After seeing their stocks take a hammering many gulped at my recommendation. Those who exercised paid a low AMT and are enjoying the low tax rate as their stock ticks back up.

If you are fortunate to have both ISO’s and NQSO’s you have a series of tax planning opportunities available. Generally you should coordinate the exercise of both types in the same calendar year to minimize or eliminate the AMT on your ISO’s. The ability to raise your ordinary income through exercising NQSO’s makes this possible.

What If I Don’t Have Money To Pay The Exercise Price?

Employees with high strike prices face the challenge of coming up with money to pay the strike price. Recently a client whose companies’ shares traded at $100 had 5,000 shares exercisable at $20. She did not have the $100,000 in cash to exercise and felt her only alternative was to pay for the exercise simultaneously from the proceeds of the sale. This is a common error and is referred to as a cashless transaction. The underlying shares in this transaction were sold in less than one year, thus the gain of $400,000 will be taxed at around 40% rather than around 20%, an $80,000 overpayment of taxes.

An alternative would be a partial cashless transaction whereby 1,000 options were immediately exercised and sold. The net cash proceeds from this can be used to exercise and hold the remaining 4,000 shares. True the 1,000 shares will be taxed at the high rate but the remaining 4,000 will not.

Another alternative is to borrow against the built in gain of $400,000 to generate the $100,000 to exercise all 5,000 shares. If you already own shares outright in the company, another choice would be to swap $100,000 worth of those shares to pay for the strike price-this is a tax-free exchange. Other strategies such as exercising prior to April 15th and filing for tax extensions can save big bucks too.

Why A Stock Option Analysis Must Be Performed:

It may appear that exercising and holding ISO’s is the best strategy, however this is not always the case. A stock option analysis should be performed which measures risk, taxes and internal rate of return. This provides a platform for a sound strategy and sharp decision-making. The analysis should be periodically updated for new grants, stock splits, re-pricing, etc.

For example, if two employees of the same company have exercise prices that are much different, an option analysis would likely suggest that the employee with the lower strike price is a better candidate for exercising and holding ISO’s. Factors such as trading price, beta and industry must also be considered. An option analysis should also outline when and where money/assets are coming from to exercise new shares and pay tax dollars. The analysis should project forward for a few years and act as a blueprint for an overall option and tax strategy.

Count On Yourself For Leadership:

A surging class of upper and mid-level option holders are often discouraged by their companies’ lack of option and tax assistance. While the employing company is vital in the option process, it is usually a limited resource for the employee option holder. Finance departments are usually inundated with administering, granting and complying with option regulations, not to mention fielding routine questions from enthusiastic employees. If outside professional tax assistance is not pursued, option holders may not know of the lurking financial issues they have, much less how to protect themselves.

To be a leader in the "paper society", one must seek expert advanced planning to better protect their future nest eggs and make the best of their already-won victories.