Equity Compensation Advisor

This is Part 2 of 5 in a Five Part ISO Series

Sometimes it is not always clear whether the option is a non qualified option or an ISO.  For an option to qualify as an ISO it must meet four requirements:

1.   The exercise price of the option cannot be lower than the value of the stock when the option is granted.
2.   The term of the option cannot be longer than ten years.  However, the option can be shorter but not longer than ten years.
3.   The option cannot be transferable except at the death of the option holder.  Once the option has been exercised, the stock may be transferred but not the option itself.
4.  If the option holder owns more than 10% of the voting stock in the company, the exercise prices of the option has to be at least 110% of the value of the stock when the option was granted and the term of the option cannot exceed five years.                                                             Lastly, the option holder must have been an employee of the company at the time the option was granted (as opposed to an outside consultant or director).  Also, the option holder must exercise the option while they are still employed by the company or within three months after their termination date.  However, if the option holder is disabled, the favorable tax treatment is extended for one year versus three months following termination of employment.

My next blog (PART 3) will focus on the Tax Treatment of ISO’s

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The Uniqueness of Stock Options

Unlike any other type of investment, Stock Options have three unique characteristics that set them apart from the crowd.

1.   Rapid Appreciation
Stock Options have tremendous upside potential.  In general a stock option may appreciate more than the underlying stock it represents.  For example, a 25% increase in the value of the stock may result in a 40% or 50% (+) increase in the option value.  As the stock appreciates, the options will normally appreciate at a faster rate.

The main reason for this rapid appreciation is due to the inherent leverage that options have.  This leverage is not necessarily a bad thing but it does create more volatility.

2.  DownsidePotential                                                                                                                                                                                                                       Just as important to realize that options have rapid appreciation, it is important to remember that the opposite is true with the drop in value.  A 25% drop in the value of the stock could result in a 50% or more drop in option value.  In fact, I have seen scenarios where a 40% drop in the stock price eliminated the entire value of all the options.

3.  Illiquidity
Holders of employee Stock Options do not have the liquidity of individual stocks.  The first liquidity event may not be for several years until the options vest.  Once the options vest, they become liquid, assuming that the price is above the original grant price.

Timing is important.   As discussed in last week’s blog, options have an expiration and it is a race against time when determining when/how/amount to exercise.

When analyzing their portfolios, the option holder needs to be aware of the tremendous risk that options have, especially if they represent a large percentage of their portfolio.

Dan’s Moral: Understanding the volatility (up and down) is critical to managing wealth.

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Did you know…….”Executives of public companies represent the largest segment of share holders with concentrated stock.”  By our definition, any one position that represents more than 20% of a portfolio is considered a concentrated position.

Why is this?  The number one reason executives of public companies hold concentrated stock is through the issuance of stock grants or options as part of their compensation; i.e. equity compensation.

Consequently, the factors behind why executives hold a concentrated position are psychological rather than fundamental.

The three most common psychological hold reasons are:

• loyalty to the company
•  future appreciation
•  tax avoidance

All risk, no reward?  In general, the financial markets reward investors for taking additional risk.  However, the markets provide no additional reward for risk that can be eliminated through diversification.  The reward normally will occur with a willingness to take on additional risk with a higher expected return.

Facts about volatility:  The volatility of the US stock market has historically been calculated at about .16’.  In other words, the market on average can be expected to drop 20% or more within a one year period.

The volatility of a large cap stock is somewhere between .25 and .5.  In other words, the drop in value of any large cap stock can be as much as 50% or more.  Furthermore, some large companies may have volatility between .4 and .8 and may see a drop of 80% or more within a one year period.

Expanding further on risk exposure, it should be understand that because of the high volatility of certain stocks, an executive whose wealth is tied to a single stock could easily be exposed to risk levels that are 4 to 8 times as high as a fully diversified stock portfolio.

For a more detailed discussion of concentrated risk see my white paper in our “Resource section” on our website http://www.executivecapitalmn.com/resources_and_events/white_papers.asp

Dan’s Moral:  Executives with a high concentration of company stock are exposed to additional risk without being compensated.

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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

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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

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

Generally, it is preferable to exercise ISOs early in the year to start the one-year holding period to qualify those shares for the long-term capital gain rate. However, with the S&P up over 10% in the third quarter, it may be time to revisit ISOs that may be ripe for harvesting. 

First, we need to project what the Alternative Minimum Tax (AMT) Buffer will be for the 2010 tax year.  This is the amount by which regular income tax is projected to exceed Tentative Minimum Tax (TMT).  The AMT is triggered when the TMT exceeds the regular income tax.

Example: It is projected that your regular income tax is $85,000 and your TMT is $70,000.  In this situation, your AMT Buffer is $15,000 ($85,000-$70,000).

For planning purposes, the bargain element (spread) on the exercise of an ISO is treated as income under the AMT, but is not treated as income under the regular income tax.  Therefore, ISO’s may be exercised up to the AMT Buffer amount without incurring any additional tax.  However, AMT credit from previous years will reduce the AMT Buffer amount.

Dan’s Moral: Knowing the amount of AMT buffer can save thousands in taxes.

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An executive who makes the decision to exercise stock options should be clear about the expenses associated with the transaction. Here are the three types of expenses to consider.

The first cost is simply the exercise price of the option. For example, if 5,000 option shares were issued at $15 per share, the cost to exercise all 5,000 shares is $75,000 ($15 per share x 5,000)—no matter what the current price per share is. 

When non-qualified options are exercised, the gain (or bargain element) is subject to withholding tax. In the above example, the bargain element subject to tax is $50,000; the gain is $10 per share ($25-$15) x 5,000 shares. However, if you are not an employee of the company (director, consultant, etc.), withholding does not apply upon exercise. Rather, the income will be reported on a 1099-MISC. When the exercised shares are ISOs (incentive stock options), the employer withholds no tax.

Lastly, the financial institution performing the transaction may impose fees, which can vary dramatically depending on the level of the institution’s involvement. In addition, a commission may be charged on the number of shares exercised.

Dan’s Moral: Look before you leap; understand all costs before exercising options.