This article has been updated to reflect a correction regarding the tax treatment of non-qualified stock options.
Stock options are like sex, says Beth Walker, founder of financial-planning firm Virtual CFO and author of An Employee's Guide to Stock Options. "Everybody wants some, everybody claims to know what they're doing, and everybody makes a mistake the first time they try it."
If Walker's claim is true, there's plenty of awkward fumbling going on. More than 50 percent of publicly traded companies award stock options, and about 10 million U.S. employees now hold them. In aggregate, Americans hold 1.2 billion options, representing $80 billion in value. Stock options, in fact, make up more than 50 percent of the total compensation for the top 10 percent of corporate executives. Yet some of those happy option holders will ultimately collect less than they expect.
In part, this reflects the complexity of options taxation. Companies dole out two distinct varieties of options: qualified stock options (also called incentive stock options, or ISOs) and nonqualified stock options (NQSOs). The tax treatment for each kind varies greatly.
NQSOs are more common because they are considered compensation and thus are a deductible expense for corporations. That's good for the company, but employees pay a price. The Internal Revenue Service treats the profit on an exercised NQSO as ordinary income, which can be taxed at 35 percent.
Employees can reduce that tax hit if they hold the net shares for more than a year, so that the resulting gains would be subject to the 15 percent long-term capital gains rate. Of course, the employee must hope that the stock price doesn't drop in the interim and swallow some — or all — of the gain.
ISOs, which are usually reserved for senior executives, must meet several strict IRS criteria regarding shareholder approval, exercise limits, timing, value, and other factors. They are, therefore, not considered compensation.
But ISOs carry another tax risk: annual gains received from ISOs often push unwitting options holders into the clutches of the alternative minimum tax (AMT), says Paul Ohanian, a vice president and financial adviser at WealthTrust Arizona. Unlike the spread on NQSO shares, the profit made on exercising ISOs is a preference item under the AMT, which means it must be calculated as part of a taxpayer's income. If a taxpayer is subject to the AMT, he or she pays at or near the highest tax rate on all income, versus paying a progressive rate that tops out at 28 percent on income only above $74,000.
Thus beneficiaries of ISOs would do well to ask their financial planners for a two-year tax projection to determine how much AMT they will pay and how much they will recover the following year as a credit, and weigh that against the risks of holding the shares.
Tax consequences aside, executives often receive less money than they expect because they hold on to their options for too long. "Options have an expiration date," warns Rod Coleman of SYM Financial Advisors, who cites a sense of loyalty to the company offering the options as one reason people cling to them. Another is greed. They want to extract maximum value, and assume that, as insiders, they will know precisely when to sell. But "the market isn't rational," says Coleman, "so don't expect an option to price to your wishes."
Instead, he advises setting up a systematic exercise and sell-off schedule based on investment goals, risk tolerance, and three straightforward evaluations — a fundamental stock analysis (earnings, projects in the works), a technical analysis (market forecasts), and an options-modeling valuation (usually Black-Scholes). All that number-crunching will yield a target price for the year or period, and that's the price that should trigger an options exercise.
Disciplined selling has another advantage: it helps individuals avoid tying up too much of their net worth in one company. Investing the proceeds of stock sales into other assets (often with a mix of tax consequences on future gains) is a great way to diversify, Coleman says. For more-immediate protection, Ohanian suggests that options holders consider buying put options, which act like an insurance policy against a drop in the company stock.
A put option is a contract that gives the holder the right to sell shares at a set price, similar to the way a stock option — also known as a call option — grants the right to buy stock. The value of a put rises when the related share price falls. If constructed correctly, the put gain should offset the loss in value of a stock option, and sometimes cover the put fees. The cost of the put varies, depending on the strike price, duration, and trading restrictions, but Ohanian says that puts are relatively inexpensive compared with the protection they offer. He suggests a one-year put.
Death and Other Life-Changing Events
Estate planning is a major consideration when seeking to maximize the value of stock options. Taxes, vesting periods, and other aspects of options are often affected by the death of the holder and subsequent transfer to others. The litany of IRS exemptions combined with the complexities posed by the expiration dates of the options themselves means that estate planning for stock options is "more immediate" than for any other personal asset, says Walker.
Other life-changing events, such as divorce, job change, or disability, also affect options planning. While the type of options at stake and state laws are important considerations, the firm's options-plan document is the real key to developing a sound strategy. The document specifies such information as situations that trigger accelerated vesting, the amount of time heirs have to exercise options, and the amount of time an employee has to exercise vested options after leaving the company.
If you do nothing else to protect the value of your stock options, Walker says, at least request a copy of your corporate options plan document, read it, and share it with your advisers. Think of it as a sex manual you aren't embarrassed to read in public.
Marie Leone is senior editor at CFO.com.
Know Your Options
Aiming to make the most out of your stock options? Find out how the IRS, state lawmakers, and your company deal with these typical situations.
Negotiating Compensation Packages: Planning to leave your job — and your stock options — behind? Think of awarded options as lost compensation that should be accounted for when negotiating a pay package with your new employer.
Termination: Most companies provide a grace period within which former employees can exercise vested options, usually 90 days. But the clock starts ticking on the employee's final day, not the day severance payments stop.
Change of Control: No company is too big to become a buyout target. Any change of control at the corporate level usually triggers immediate options vesting, which also can lead to immediate gains, and immediate payment of taxes.
Divorce: Options are "fair game" and can be transferred as part of a divorce settlement. The employee must pay taxes on the equity transfer, but the ex-spouse pays taxes on all postexercise gains.
Bankruptcy: An IRS exception allows ISOs to be transferred to a bankruptcy trustee if an individual becomes insolvent.
Disability: The plan document governs the definition of disability. But in many cases, only living wills or a financial-power-of-attorney document, with updated HIPPA requirements, can cede control of options to someone other than the original holder.
Death: Transfers are permitted to heirs. ISO heirs can defer taxes and receive capital-gains treatment after a holding period; NQSO heirs treat exercise gains as ordinary income. If the stock is held for a year, and appreciates after exercise, the holder receives capital gains treatment for NQSOs.
Sources: Beth Walker, Rod Coleman, and Paul Ohanian