Employees with stock options are faced with a tough dilemma. In order to convert the option into real value, they must cash it in. If they cash the option in, they realize the intrinsic value of the option, the difference between the option price and the current market value. This removes the risk of having the option become worthless. However, by exercising, they lose any remaining time value left in the option and they incur the tax liability.
There are a variety of strategies designed to deal with this dilemma.
1. The “Need Approach”: Cash in the option when you need the money. This clearly does nothing to balance investment risk and reward
2. The “Prediction Approach”: Many optionees and some advisors, try to time the harvesting of the stock based on some prediction of how the stock is going to perform. The reliability of such perditions is not possible. This approach often fails and sometime with spectacularly disastrous results.
3. “Timeline Approach”: There are basically three options with this approach:
a. Exercise as soon as possible. In this case, exercise options as soon as they vest as long as you are in the money. This approach is conservative but wasteful because you will lose all of the time value of the option
b. Exercise as late as possible. In this case, options are exercised just before they expire. This approach avoids wasting any of the options value but leaves the optionee exposed to risks of stock devaluation for a very long period of time.
c. Select a random period of time such as 1 year before expiration. The idea here is to minimize the risk and still receive some time value for the option .
4. A Balance Approach: This approach provides the greatest possible return for the least risk. It is also different for just about everyone. The approach here is to convert a high-risk investment, into a normal diversified investment, while not losing a large portion of its value. Thus, converting the stock in the value to be gained is significantly larger than the time value that is lost. Thus, options deep in the money should be cashed sooner than those with smaller gains. One also has to take into account the value of the option relative to ones overall net worth. Options representing large portions of net worth should be exercised sooner.
Tax Implications for Nonqualified Stock Options
If a stock is exercised after vesting, then the optionee reports compensation income equal to the amount by which the stock value exceeds the exercise price. This amount is now included in the tax basis of the stock, so they have a basis equal to their fair market value. Any subsequent change in value will result in capital gain or loss, which will be long-term if the sale occurs more than a year after the option was exercised.
Most optionees exercise and hold for a year to take advantage of long-term capital gains treatment. This however exposes them to “capital loss whipsaw”. Imagine you own PSI Net with a $100,000 gain at the time of exercise. The stock proceeds to go down $90,000 before the shares are sold a year later. Now you will report $100,000 of in compensation income with a capital loss of $90,000. You can only deduct $3000 of the capital loss and will end up paying ordinary income taxes on $97,000 even though her true profit is only $10,000!
The benefits of exercising and holding nonqualified stock options do not outweigh the risks associated with holding them over time.
Tax Implications for Incentive Stock Options
AMT tax has made it more difficult for those with ISOs who’s with income between $150,000 and $380,000. This is because the AMT tax increases the tax rate for those income brackets. Individuals making more than $382,000 already are paying higher taxes and are not affected by AMT (ISO impact). Options are to exercise and sell, exercise and hold for one year in hopes to reduce the tax liability, or a combination of the two.
There is a significant amount of risk in holding the stock for a year in hopes of reducing the tax on the gain. This is due to the fact that you will pay tax in the year you exercise and may lose value in the stock by holding it an additional year. To get the best of both worlds, possible capital gains treatment with lower risk, consider selling 65% of the stock immediately and holding the remainder for a year. This allows you to take some of the risk off the table and still reap the benefit of the capital gains tax. Ratios will vary depending on the amount of the gain and the tax credit. It is important that you consult your tax advisor before making any decisions as they relate to non qualified and qualified stock options.
Source: FPA Seminar on Stock Option Planning for Corporate Executives by Kay Thomas, Founder of the National Board of Certified Option Advisors.
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