Equity Compensation Advisor

Simply stated, there are two components that make up the value of a stock option.  In order to better understand the value of stock options we need to become familiar with these two components referred to as the intrinsic value and the time value.
Breaking it down to the next level, we  define the intrinsic value as the difference between the current stock price and the exercise price.

For example:   Let’s examine the event of 5,000 stock options issued at $25 per share.  At the time of exercise, the  current price of the stock is $40 per share, thus, putting the intrinsic value at $75,000 (($40-$25) X5000).  This factor is often referred to as the bargain element.
Progressing along to the time value of the option, we can represent that the time value is the value based on the potential increase in the stock, between now and the expiration of the option.  Keep in mind that in general, most options have a life of 10 years.  The longer the option has until expiration the greater the time value.   Furthermore,  the time value will continue to diminish over time and at expiration the time value becomes zero.
When we tie it all in together, it is  important to remember that the time value of an option can vary drastically depending on the expiration, as well as the volatility.
Dan’s Moral:  The value of stock options can be worth more than the intrinsic value.  Be careful not to be discouraged by the current cash-in-value (intrinsic value) of your options as the overall value when including the time value may be much higher.

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For more information on Dan Langworthy and Executive Capital, LLC you can also visit our website: http://www.executivecapitalmn.com and view Dan’s profile on Linkedin http://www.linkedin.com/in/danlangworthy

Securities and advisory services offered through LPL Financial, a Registered Investment Advisory, Member FINRA/SIPC

Taxation of Incentive Stock Options – ISO’s
In this, my fifth and final submission to the blog series on the taxation of different equity awards, we examine the “Taxation of Incentive Stock Options” or ISO’s, the benefits and tax implications.

Tax Benefits:  Holders of ISO’s are eligible for certain potential tax benefits that are not available in the previously discussed equity awards.  The main tax benefit of ISO’s is the ability to convert compensation income into long-term capital gain.   In order to qualify for the long- term capital gain rate, the option holder must hold the stock for a specified period of time after exercise.

There are four tax benefits of ISO’s over other equity awards:

1.  At the time of exercise, the option holder does not report any income for regular tax purposes.
2.  If the option holder holds the shares long enough to avoid a “disqualifying disposition” (for future blog discussion) the bargain element (gain) will be taxed as long-term capital gain.
3. The bargain element from the exercise or profit from the sale is not subject to income tax withholding or Social Security tax.
4. If the shares are sold in a disqualifying disposition, they may still be able to limit the amount of income reported to the actual profit from the purchase and sale, versus a non qualified option that must report the actual gain at the time of exercise.  This applies regardless if the shares drop in value after the exercise.

So exactly what are the potential tax implications when ISO’s are exercised?  In most cases an option holder who exercises an ISO, and holds the shares beyond the end of the year of exercise, will be subject to AMT tax.

Dan’s Moral: ISO’s give the option holder the ability to convert the gain into long-term capital gains if the proper strategy is used.

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For more information on Dan Langworthy and Executive Capital, LLC you can also visit our website: http://www.executivecapitalmn.com and view Dan’s profile on Linkedin http://www.linkedin.com/in/danlangworthy

Securities and advisory services offered through LPL Financial, a Registered Investment Advisory, Member FINRA/SIPC

Nonqualified Stock Options
As the series continues, Part 4:  Non-qualified Stock Options are explored as we compare similarities, differences, tax implications, and timing for exercising options.  See example below:

As mentioned in my previous blog, Non-qualified Stock Options (NQO’s) are similar to Stock Appreciation Rights (SAR’s).                                         

What are the differences?   The main difference is that SAR’s provide the holder with the right to receive cash and NQO’s provides the holder the opportunity to by a fixed number of shares at a price determined when the options were granted.

• In summary:   A NQO holder does not report income until they exercise the option.  At the time of exercise, the option holder must pay the exercise price (grant price) and is taxed (compensation income) on the difference between the exercise price and the current price.

Example:

• If the option holder exercised all the options they would report compensation income of $40,000 ($45-$25 X 2,000).
• If the holder is an employee of the company, the income from exercising the option will be subject to withholding and social security tax.

Dan’s Moral:  Because there is no cost or tax implication to the holder at the time the option is granted, options allow the holder to participate in the appreciation of the stock with no cost.

• Please be sure to subscribe to our blog to be automatically notified as the series continues on the “Tax Implications of the Five Types of Equity Compensation, Part 5″. 

For more information on Dan Langworthy and Executive Capital, LLC you can also visit our website: http://www.executivecapitalmn.com and join Dan’s network on Linkedin http://www.linkedin.com/in/danlangworthy

Securities and advisory services offered through LPL Financial, a Registered Investment Advisory, Member FINRA/SIPC

In this five part series we have covered the tax implications of Restricted Stock Grants and Restricted Stock Units.  In part three, we will be discussing the tax implications of Stock Appreciation Rights (SAR).

What are Stock Appreciation Rights:

Stock Appreciation Rights (SAR’s) provide the executive with the right to receive cash in the amount of increase in value of a specified number of shares. The following are some common questions and answers about SAR’s that should help define and differentiate them.

How are SAR’s similar to options:

SAR’s are similar to options in that the executive determines when to exercise the shares.

How do SAR’s differ from options:

Unlike an option, the SAR does not require the executive to come up with the cash at the time of exercise.  By simply exercising the SAR, the executive receives cash.

Note:  However, sometimes companies may grant SAR’s that pay off in shares of the company stock.  By paying off in stock, the company does not need to come up with the cash.

This brings us to the main objective — Taxes:

• SAR’s are taxed the same as non qualified stock options.
• When the executive is granted the SAR or when it becomes exercisable, there are no tax implications.
• At the time of exercise, the executive reports ordinary income on the amount of cash received.
• If the executive receives shares, they will report income equal to the value of the shares the day they are transferred.

Dan’s Moral:  SAR’s provide the executive a way to participate in the appreciation of their company stock without having to come up with money out of their own pocket at the time the SAR is granted, as well as when they are exercised.

• Please be sure to subscribe to our blog to be automatically notified as the series continues on the “Tax Implications of the Five Types of Equity Compensation, Part 4″. 

For more information on Dan Langworthy and Executive Capital, LLC you can also visit our website: http://www.executivecapitalmn.com and join Dan’s network on Linkedin http://www.linkedin.com/in/danlangworthy

Securities and advisory services offered through LPL Financial, a Registered Investment Advisory, Member FINRA/SIPC

Restricted Stock Units; Part 2 of my five-part blog series on the tax implications of the five types of equity compensation:    Restricted Stock Grants, Restricted Stock Units, Stock Appreciation Rights, Non-qualified Stock Option, Incentive Stock Options

 Throughout this series, we will discuss the tax implications of each of the five types of equity compensation first as described in my previous blog published 11/29/2011 (“Five Types of Equity Awards”). 

In my previous blog, Part One of the series, we discussed Restricted Stock Grants, and the tax implications involved.  Part Two consists of defining the second type of equity compensation; Restricted Stock Units (RSU’s), and important components including forfeiture, tax consequences, timing and more.

• Restricted Stock Units (RSU’s) are very similar to Restricted Stock Grants with one exception, the time when the shares are transferred.  Restricted Stock Grants are transferred at the time of the grant even though the executive may not have direct access to the shares due to possible forfeiture based on the vesting schedule.
• In the case of RSU’s the company does not transfer shares at the time of the grant.  The shares are transferred once the employee has worked long enough to meet the required time period.  Fundamentally, the employee would not be entitled to any dividends until the shares are transferred.  Also, due to the fact that the shares are not transferred at the time of grant, the executive cannot file a section 83b election to convert future appreciation of the shares to capital gain. 

Keeping in mind that since the executive does not have access to the shares when granted, there are no tax consequences until the shares are transferred.    At the time of transfer, the shares become vested and the executive will report compensation income on the entire value of the shares.  This amount is the cost basis for tax purposes.

Dan’s Moral:  Because the company determines the timing and restrictions placed on RSU’s, the only decision the executive needs to make is whether to hold the shares at the time of transfer or sell them.

• Please be sure to subscribe to our blog to be automatically notified as the series continues on the “Tax Implications of the Five Types of Equity Compensation, Part 3″. 

For more information on Dan Langworthy and Executive Capital, LLC you can also visit our website: http://www.executivecapitalmn.com and join Dan’s network on Linkedin http://www.linkedin.com/in/danlangworthy

Securities and advisory services offered through LPL Financial, a Registered Investment Advisory, Member FINRA/SIPC

This is the first entry in a five-part blog series on the tax implications of the five types of equity compensation.  Throughout the the series, we will discuss the tax implications of each of the five types of equity compensation, as described in my previous blog published 11/29/2011 (“Five Types of Equity Awards”).

Part One:
We will begin part one by focusing on Restricted Stock Grants.  A restricted stock grant is stock that a company issues to an employee and is restricted (not vested) until the employee can terminate their employment without forfeiting their shares (vesting date).

The tax treatment for restricted stock can be complicated based on the type of restriction the company has placed on the shares and whether the executive elects to file the 83b election when the shares are transferred to them (future blog).  In this blog we are going to assume “substantial risk of forfeiture” (described later) on the shares and the executive does not file the 83b election.

The tax implications for restricted stock mentioned above does not exist until the shares become vested.  In other words there is no income to report until the year in which the shares vest.  Once the stock is vested, the executive would report compensation income based on the value of the stock on the vesting date.

Usually, once the shares are transferred by the company to the executive, they become vested and are then taxable.  Stock is considered vested when either of the following actions occurs:

• The shares are transferable.  This occurs when the executive can transfer the shares to any other person, but only if that person accepts the shares and are not subject to “substantial risk of failure.”

“The stock is not subject to “substantial risk of failure.”

• This means that the executive will lose some or all of the value of the shares unless they continue working for the company for a specified period of time.

Dan’s Moral:  As you can see, simply receiving restricted stock from your employer can be more complicated than it might appear, based on the restrictions placed on the shares and the vesting schedule.

Please be sure to subscribe to our blog to be automatically notified as the series continues on the “Tax Implications of the Five Types of Equity Compensation”.

Securities and advisory services offered through LPL Financial, a Registered Investment Advisory, Member FINRA/SIPC

Knowing the different types of equity awards that corporations issue and what the executive owns is important.
• Restricted Stock Grants
These awards of company stock are referred to as restricted because the executive is restricted from selling the shares for a period of time. Usually this is through a vesting schedule so that employee will forfeit some or all of the shares if they terminate before the shares are vested.
• Restricted Stock Units (RSU’s)
The main difference between restricted stock units and restricted stock grants is the date when the company transfers the shares. Restricted Stock Grants are transferred at the time of the grant. Restricted Stock Units transfer the shares at the time of the vesting date. Therefore, the holder of the RSU’s will not benefit from any dividends that have been paid prior to the date of transfer.
• Stock Appreciation Rights (SAR’s)
SAR’s allow the executive to receive cash in the amount equal to the increase in value based on the original stock price and the number of shares that were issued.
SAR’s are similar to options because the holder determines when to exercise the rights subject to the vesting schedule. Exercising the SAR provides the holder with immediate cash unless the company granted the SAR’s to pay off in stock.
• Non-qualified Stock Option (NQO)
NQO’s permit the option holder to purchase a specific number of shares of company stock at a specific price the day the company granted the options. The option holder must pay the exercise price (grant price) at the time of exercise. The difference between the exercise price and current price is the gain (bargain element). NQO’s are options that do not qualify for special tax treatment.
• Incentive Stock Options (ISO’s)
The main difference between NQO’s and ISO’s is ISO’s do qualify for special tax treatment, allowing the option holder to convert some or all of the income into capital gains. The rules and strategies to take advantage of the special tax treatment can be complicated. The main reason a company would issue ISO’s is to provide a tax benefit to the option holder.
I will discuss the tax consequences of each of these equity awards in the following 5 part series.

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One of the more common questions I am asked from clients is “What are the tax consequences of owning stock options?” This remains a hot topic for discussion at any time of the year. As tax season quickly approaches, having a thorough understanding of the tax implications involved can be crucial to minimizing taxation exposure . A more in-depth, comprehensive look at the tax consequences will be explored in a later blog to come. For the purposes of this discussion, I intend to illustrate a general understanding including a hypothetical example.

Taxability-wise, stock option plans raise a number of questions. For example, is the exercise of the option taxable? If not, when is the transaction subject to tax? These questions are very broad and there a many determinants of the taxability of stock options. For tax purposes, there are basically two types of stock options. Lets break this down in simple form.

Differentiation:

The first step is determining whether the options are Type 1: Non-qualified or Type 2: ISO’s (Incentive stock options).

ISO’s receive special tax treatment and can be very complicated. (In a later blog we will delve deeper into the special tax treatments and elaborate on taxability issues and how they relate.)

The tax implications of non-qualified stock options are fairly straight forward.

Implications:

Simply stated, the employee does not report income at the time they receive the options or when they vest. Upon exercising the option, they would report compensation (ordinary) income equal to the difference the amount paid to buy the option (grant price) and the current value of the stock. This income is reported whether the stock is sold immediately in a cashless exercise or if the stock is held. If the stock is held, the current market price is the new basis for the shares.

Example: (This is a hypothetical example and is not representative of any specific investment. Your results may vary)

Steve has 5,000 shares of non-qualified stock options with a grant price of $15/share. The current price of the stock is $25/share. If he paid $75,000 (5,000 x $15) to exercise the shares that are worth $125,000 (5,000 x$25) he would report compensation income of $50,000 ($125,000-$75,000).

Dan’s Moral: Understanding your stock option tax consequences can be daunting and ultimately, careful consideration of how and when to exercise those options to minimize your tax liability is essential.

Daniel Langworthy is the founder and president of Executive Capital, LLC, an investment firm working exclusively with Executives of public companies.

Daniel Langworthy does not provide tax advice. Please consult a qualified tax advisor.

Securities and advisory services offered through LPL Financial, a Registered Investment Advisory, Member FINRA/SIPC

As I had indicated in my November 2010 blog, it is normally preferable to exercise ISO shares early in the year to start the one-year holding period to qualify for the long-term capital gain rate.

This blog will explain the reason behind the early exercise and the impact on AMT (alternative minimum tax). The primary advantage provided by ISO shares is the ability to have the bargain element (gain upon exercise) taxed as a long-term capital gain instead of as ordinary income.

Currently, the long-term capital gain rate is less than half of the top marginal tax rate, so the tax savings is substantial. In order to be eligible for the ISOs to be taxed at a long-term capital gain rate, the option holder must meet both of these requirements:

1. No disposition occurs within two years from the option grant date.
2. No disposition occurs within one year from when the option is exercised and transferred to the option holder.

When these two criteria are met, the bargain element is taxed as a long-term capital gain. This special holding period is often referred to as a qualifying sale.

The second requirement—shares from exercise must be held for a year—is challenging. The bargain element is subject to AMT in the calendar year of exercise. If the value of the shares was to drop substantially before the one-year holding period ends, the option holder may own shares that are worth less than the AMT tax liability. There lies the rub.

The question becomes: “How do I obtain a long-term capital gain rate after exercising my ISO shares without the added risk of the shares going down?” The answer is: “Exercise ISO shares as early in the calendar year as possible.” The tax code indicates that if ISO shares are sold before the end of the calendar year in the year of exercise, the bargain element would be subject to ordinary income and the AMT would be eliminated.

By exercising ISOs early in the year (January, February), the exposure of the stock dropping substantially to meet the one-year holding period is only a month or two versus six months or longer for ISOs exercised in June or beyond.

Dan’s Moral: The early ISO exerciser gets a head start on the special holding period and is ahead of the game.

Daniel Langworthy does not provide tax advice.  Please consult a qualified tax advisor.

Securities and advisory services offered through LPL Financial, a Registered Investment Advisory, Member FINRA/SIPC

As a follow-up to my last blog about the large tax implications from exercising nonqualified stock options (NQSOs), let’s look at converting the bargain element of incentive stock options (ISOs) into long-term capital gains.

Except in rare situations, exercising ISOs will produce the same or better tax result, taking AMT (alternative minimum tax) into account.

Here are the tax benefits for ISO holders:

1. At the time the options are exercised, there is no regular income tax.
2. If the shares are held long enough to avoid a disqualifying disposition¹, any profit from the exercise will be taxed as long-term capital gain.
3. The bargain element from exercising ISOs or selling shares later is not subject to income tax withholding or social security tax.

An option holder who exercises ISOs and holds the shares for a year or more after exercising them will be subject to AMT on the bargain element regardless of the stock price. 

Obviously, the risk associated with ISOs is being subject to AMT in the calendar year of exercise, then holding the shares beyond the calendar year in which they were exercised to obtain the long-term capital gain rate—only to see the stock drop before the one-year holding period ends. As mentioned in an earlier blog, one way to reduce the risk is to reduce the holding period in the year after exercise, i.e., exercise ISOs early in the year so shares can be sold by December 31 to eliminate the AMT liability.

Dan’s Moral: Timing is everything when exercising ISOs, then holding and selling shares to reduce the tax liability by more than 50%.

¹Disqualify disposition: In order for the option holder to avoid a disqualifying disposition they must meet both of the following requirements:

1. No disposition within two years of grant date;
2. No disposition within one year after the shares are transferred (exercised).

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