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Investors with concentrated stock positions created by employer granted option positions face dual risks. These risks result from lack of diversification and the tax consequences of exercising and/or selling their holdings. The objectives for holders of single stock positions who wish to maximize their wealth involve management strategies to: 1) enhance yield or income, 2) protect the price of the position, 3) defer taxes, 4) diversify against the unique risk of one stock, and 5) increase liquidity. There are a variety of tactics that can be used by option holders. However, none offer guarantees and all carry risks along with the advantages. Option holders who require immediate liquidity or feel that the stock has reached a peak may wish to exercise and sell their stock. For both Incentive Stock Options (ISOs) and Non-Qualified Options (NQs) the difference between the option price (your cost) and the current stock price will be taxed at ordinary income tax rates. This does provide liquidity and cash to invest elsewhere for diversification and income. It does lock in the price, but at the price of higher taxes. Holders of NQ options who believe their stock will continue to appreciate may wish to hold their positions for as long as possible. If their tax picture puts them in one of the lower brackets, they may wish to exercise a smaller portion of their holdings, allowing them to stay within the lower tax brackets. Holders of ISOs have more choices. If two years have elapsed from grant to exercise, the owner can exercise and hold the stock for at least one year, at which time the subsequent sale would be taxed as a capital gain (loss) rather than ordinary income. If they exercise and hold, the difference between the exercise price and the current market value is treated as a tax preference for Alternative Minimum Tax calculations. Any AMT taxes paid generate a credit against future capital gains taxes resulting from future sale of the stock. But, if the stock depreciates after exercise, the AMT paid may not be recovered. Once an ISO is exercised, the holder may borrow against the stock in a Brokerage account to increase liquidity or buy other securities for diversification. Although this generates liquidity and diversification while continuing to defer some taxes, it does not protect the price. Further, borrowing on margin can be risky if the price of the stock plummets, forcing the investor to either put more cash in the account or sell the underlying stock. The latter action could trigger ordinary income taxes if the stock has not met the one-year holding period. A number of stock option strategies can be used with ISO stocks held in a brokerage account to generate income and price protection while deferring taxes. In general, while these goals may be accomplished, the price to the owner is the inability to participate in strong upward price movements of the underlying security, or the cost of the option purchased. As an alternative to any of the above, I recently put together a charitable trust strategy for the holder of a large number of ISO and NQ options. In this case, the option owner exercised the ISOs and paid the AMT taxes. He held the stock for one year before donating the stock to a Charitable Remainder Unitrust with makeup (NIMCRUT). This transaction created an immediate income tax deduction that he used to offset income from the exercise of some of his NQs that he used to invest forfurther portfolio diversification. The client will eventually sell his donated stock, free of all taxes. He plans to reinvest the proceeds in a diversified portfolio of investments that are likely to grow without producing accounting income which, under the terms of the trust, would be required to be distributed to him. Later, when he is ready to retire, he will begin withdrawing the undistributed income from the trust, and will do so for the rest of his life. By doing so he has minimized and deferred taxes, provided for diversification, protected his price, protected the assets from creditors, and will ultimately benefit a charity. |
