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Stock options are creating a staggering amount of wealth daily just down the road in Silicon Valley. But, quicker than its creation can be its loss through improper tax planning or poor investment strategies. Stock options are corporate America’s method of printing money to reward employees for their efforts. A stock option program entails the granting of the right by a company to its employees to purchase company stock, generally at a price well below the prevailing market price. These grants typically have a vesting (waiting) period before the employee may exercise the option. In theory, this type of stock option is designed to maintain the employee’s loyalty while encouraging him to give his maximum efforts to achieve company profitability. Of course, this should translate into a higher stock price. Often newer companies need their cash resources to fuel continued growth, so rather than pay high wages, they reward employees with lucrative stock option benefits which do not require up-front cash from company coffers. Besides the real estate agents and foreign car salespeople, nobody could be happier about stock options than Uncle Sam’s tax collector. The vast wealth will swell federal tax coffers today and in the future. When option holders exercise their options in taxable transactions, Uncle Sam’s pocketbook grows. Years from now, after this wealth has grown and become subject to upwards of 55% estate taxes, Uncle Sam is still winning. According to a study conducted by Deloitte & Touche, 10% of 8,000 publicly traded companies currently offer stock options to a majority of their full-time employees. Those lucky enough to be the recipients of a stock option face two major risks in the management of this wealth. Taxation can easily take up to 45% off the top. The lack of diversification created by holding concentrated positions in company stock, either in option form or the stock itself, exposes the holder to a variety of avoidable investment risks. An asset allocation strategy can mitigate some of this risk, providing the holder of the option is willing to walk through the tax minefield on the way to diversification! Understanding how stock options are taxed is the first step in planning. Two types of options are most common: Incentive Stock Options (ISO) and Non-Qualified Stock Options (NQs). Each of these is treated differently for income tax purposes. Upon exercise of an ISO, the employee pays the exercise price and takes possession of the stock. If the employee waits two years from date of grant and at least one year from date of exercise to sell the stock, the transaction receives capital gain (loss) tax treatment. If either of those waiting periods is violated, the transaction is taxed as a short-term trade, subject to ordinary income tax rates. It is important for the holders of ISOs to realize that when they exercise their option, the difference between the exercise price and the fair market value at time of exercise is a tax preference item for Alternate Minimum Tax calculations. Even though they continue to hold the stock, they may pay taxes on the transaction through the AMT calculation. When they do sell the stock, if a capital gain results, they will receive a credit against that tax for theAMT taxes previously paid. Non-qualified options are taxed like ordinary income at exercise. When the employee exercises, s/he typically initiates a simultaneous buy and sell transaction. This is taxed as ordinary income and shows up on his W-2 as wages paid. |
