For many high-level employees, stock options may have become too much of a good thing. Many employees have amassed enormous wealth from stock options, but their long-term financial success may depend too heavily on the continued success of their employer.
In today’s changing economy with employment creeping slightly higher and a new administration in the White House, it is prudent to explore a variety of investment strategies. If a high percentage of the executive’s net worth is concentrated in their company’s stock, now is the time to diversify. Several considerations must be evaluated when planning the exercise or sale of the employee’s securities, including: the risk the employee is willing to assume, the risk to the business and tax considerations. A plan should be carefully developed to exercise the options for diversification and to avoid tax consequences.
When options are granted there is no tax event be-cause the options are qualified or non-qualified. The tax treatment varies when the options are exercised de-pending on whether the options are qualified or non-qualified.
Non-Qualified Options (NQ)
The tax treatment of NQs is simple but it also the most expensive from a tax perspective. When NQs are exercised, ordinary income in the amount of the "spread" is recognized. The spread is the fair market value of the shares on the date of exercising less the cost of the option. This income will be included in the individual’s W-2 and the employer will be required withhold 28% and 5.95% for federal and state taxes respectively. The spread will also be subject to - Social security, Medicare and local taxes. When NQs are exercised, sell the security immediately because the cash will be needed for the cost of the options and the taxes. All options will expire in ten years and some cases earlier. Hold onto NQs for as long as possible to allow the options to grow tax deferred. However, balance this decision of holding the options based on the overall investment approach and the cur-rent diversification of the portfolio.
There is little to no tax planning with NQs. Exercise these options when the stock price is high. However, they will help with the tax implications of Incentive Stock Options.
Incentive Stock Options (ISO)
The planning comes into play when dealing with ISOs. If the executive properly plans, taxes can be cut in half with ISOs. Options that are exercised and held for one year will not be subject to regular income taxes in the year the shares are exercised. Additionally, the shares that are held more than one year would receive capital gain treatment. Therefore, the employee’s tax burden will be reduced from 39.6% to 20% for federal income tax purposes.
However, the amount of the "spread" from the ISO will be a tax preference item that will affect a second tax calculation called Alternative Minimum Tax (AMT). When calculating the AMT, adjustments are made to taxable income based on both preference items and exclusion items. Preference items result from timing differences, such as the spread on ISOs that have been exercised, while exclusion items result from permanent differences, (Example of exclusion items are state and local taxes.) Once the AMT is calculated, it is compared to the per-son’s regular tax rate and the higher of the two must be paid.
Every year there is a gap between the regular and AMT tax liability. For options holders, this gap is very important. Exercise just enough shares so full advantage of this gap can be taken and payment of additional taxes avoided. If planning is done properly, the tax burden can be reduced by half and in some cases entirely eliminated.
When working with ISOs, do not wait until the options are close to their expiration date. This is in deep contrast as discussed with NQs. When the employee waits until the options are going to expire, the AMT may be triggered because more options may have to be exercised than originally intended. ISO planning starts when options appreciate in value. Exercising the options gradually may help avoid triggering the AMT exposure and provide greater diversification over the years.
Several factors must be considered to determine the approach for selling and exercising stock options that will result in the lowest taxes overall. Consult with a financial advisor before implementing any of these techniques. Each individual’s goals, objectives and in-vestment history are different, so specific advise should be tailored to each situation.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.