Challenge of success: advising corporate executives about stock options.

As accounting rules change and investigations of backdating continue, stock options as a form of compensation have become more complex--and less popular. Still, stock options remain a significant form of compensation for many executives, especially in California.

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Many companies, in the start-up phase and well-established, grant new options. Additionally, executives who years ago received option grants often hold unexercised options or shares of their company stock obtained from previous exercises.

The development of a strategy for stock options goes beyond tax advising. Ideally, the process starts with the adviser gaining an understanding of the executive's financial goals and capacity for risk. Moreover, the level of investment diversification and investor psychology play a role.

To add to the complexity, executives are faced with legal and corporate restrictions on how and when their stock may be sold--restrictions which go beyond the scope of this article, but must be considered.

Further still, while tax implications are a major concern and executives may be tempted to adopt tax-minimization strategies since they hold the possibility of building greater wealth. If they don't address these other factors at the outset, the evaluation of tax consequences would be done in a vacuum, and they may not recognize the inherent risk in tax-minimization strategies to magnify losses if the stock price declines.

COMPENSATION PLAN

If you're working with executive clients with substantial options, it's important to start with a clear understanding of their overall compensation: salary, bonus, deferred compensation plan and other forms of stock compensation besides options (e.g., restricted stock grants). These other forms of compensation will be relevant when evaluating the executives' potential net worth, tax planning and overall concentration of their personal wealth in the company stock.

UNDERSTANDING STOCK OPTION GRANTS AND RESTRICTIONS

Regarding the executives' stock options, the adviser should understand the details of the company plan, option agreement and specific grants--including when options can be exercised or expire under a variety of circumstances, such as death, disability and termination of employment. The type of option--Non-statutory Option or Incentive Stock Option--will determine potential tax planning.

Generally, ISOs have the potential for more favorable tax treatment. If holding periods are met, ISO shares exercised and held are taxed at capital gain rates, rather than ordinary rates, when sold. The holding periods include two years from date of grant and one year from the date of exercise.

When exercised, the bargain value (fair market value less exercise price) is taxable for alternative minimum tax purposes--although AMT owed as a result of the exercise generates a credit, which may be recoverable in the future. Full recovery may be problematic.

With NSOs, AMT is not an issue, but the bargain value is ordinary income at the time of exercise, and any future gain (or loss) is capital gain/loss when the stock is sold. Thus, ISOs have the potential of being taxed at much lower rates, particularly if AMT credit is recovered.

To qualify as ISOs, certain requirements make these grants more restrictive or complex, including:

* Exercise price must not be lower than the fair market value of the stock when the option is granted;

* Limitations on the value of options that may be exercisable in a given year (this requirement often causes confusion); and

* Options may only be exercisable within three months of employee termination.

Beyond the tax treatment of the options, it is important to understand the contractual aspects of the option agreement and grant, including:

* Vesting schedule;

* Allowance of "early exercise" of the options before the options vest to enabling potential use of an IRC Sec. 83(b) election; and

* Specific provisions that may apply if the company is acquired, such as, will there be acceleration of vesting?

It's important to recognize there may be a risk that the company could grant ISOs that may be later deemed NSOs or be subject to deferred compensation issues under IRC Sec. 409(a) if it's determined that the company granted an option below fair market value. Private companies that are not careful to properly establish stock price may put executives at risk in certain situations.

Another essential step is being aware of any legal or corporation-imposed restrictions that may impact the executive's flexibility to exercise or sell shares.

Although this is beyond the scope of the article, some of the considerations include:

* Trading windows that determine when executives may sell their stock, typically tied to earnings announcements and other news.

* "Blackout periods" restricting sale of stock over extended time periods (i.e., tied to IPOs or other events).

* Insider trading restrictions applicable to high level executives. Development and implementation of pre-determined trading plans (i.e., IRC Sec. 10b5-1 plans) may be used to address these concerns.

The executive (and often the adviser) should consult with corporate counsel to understand these restrictions.

DEVELOPING STRATEGIES AND OVERCOMING BARRIERS TO THEIR SUCCESSFUL EXECUTION

Ultimately, the most significant--though unpredictable--variable in determining wealth generated by an executive's stock option strategy is the price of the stock when sold. To compensate for the uncertainty in stock price, the adviser can help clients develop strategies based on their goals, factoring in their capacity and tolerance for risk.

Identifying an executive's financial goals--which may, for example, include career changes, retirement, college funding, entrepreneurship--should be a starting point. Then, developing a clear financial plan to identify funds needed to achieve these goals should drive the executive's strategy.

Most executives are inadequately diversified. Even if they have capacity to achieve their goals through their options, other sources of compensation and investments they could be at risk if the stock declines. Some executives consciously choose to take on such risk. Others may underestimate the potential impact of such risks on their financial goals and are better served adopting a plan to diversify their company options/stock holdings.

An example of a diversification plan is selling stocks immediately to fund financial goals and investing the proceeds in a diversified portfolio that is less vulnerable to losses. An alternative plan may involve selling predetermined amounts at regular intervals. The latter could be established as part of a SEC rule 10b5-1 plan applicable to certain high-level executives.

Creating a diversification plan may sound simple, but there are barriers to successful execution, such as corporate or legal restrictions, and vesting also may limit when stock may be sold. And the client's decision-making behavior often has an even greater impact on the timing of diversification.

Studies in behavioral finance have found that individuals often make investment decisions or take actions that are not rational and may impede diversification, including:

* Overconfidence in one's ability to make decisions, which can lead to risk taking. For example, assuming ability to predict stock price.

* Overreaction: basing decisions on recent patterns of the stock price by assuming a recent upward trend in the price will continue.

* Regret avoidance: reluctance to sell a stock that has gone down in an effort to win back previous losses.

Most investors are averse to losses and experience more pain from a loss than pleasure from equivalent gain. However, they may not fully realize this until they have experienced it and may wish they had diversified more.

In situations where executives may not approach their investment decision-making rationally, the financial adviser can help their clients recognize these thought patterns and adopt a more prudent course.

INTEGRATING TAX PLANNING

Rather than focusing on minimizing taxes, executives are better served by concentrating on their personal financial goals. Pursuing strategies to minimize taxes by exercising and holding options of either type can create substantial risk that magnify losses and could even cause insolvency. (See "Changing Tides: Real Taxes on Virtual Income: The ISO Dilemma, California CPA, July 2001 and "Worth the Risk?," California CPA, July 2002 for a discussion of these risks).

Generally, tax minimization strategies carry more risk when the employee is granted options at an established company. At established companies, exercising options and holding the stock carries more investment up front, not only to exercise the option, but also the payment of tax on the bargain element (AMT if an ISO, regular tax on NSOs).

At early-stage companies, the value of stock exercised and taxable income may be very low. Thus, a buy-and-hold strategy may not expose the client to much financial risk while setting the stage for significant tax savings if the company stock increases in value dramatically.

This can be accomplished through an IRC Sec. 83(b) election, which accelerates the recognition of taxable income to the time of exercise rather than when the options vest. Future appreciation is then taxed as capital gains.

If the exercise with a Sec. 83(b) election takes place shortly after the options are granted, the taxable income from exercise may be negligible if the stock price has not increased significantly.

However, there are potential pitfalls:

* Application of the Sec. 83(b) election for ISOs is not the same as for NSOs as clarified by the IRS in final regulations. For ISOs the election applies for AMT purposes, but not regular tax. This could have a negative result if the stock is sold as a disqualifying disposition, since ordinary income will be triggered as of the vesting date.

* The election must be properly filed within 30 days after exercise to be valid.

Tax planning issues for corporate executives also may include incorporating the impact of golden parachute payments under IRC Sec. 280(g). Advisers can help highly compensated executives position themselves favorably to avoid or minimize excise tax that could arise in the event of a change of control. The calculation of excess compensation that is subject to excise tax is based on amounts above average prior year compensation.

Therefore, wage income from option exercises in years prior to the change in control serve to raise the base amount, making it less likely an excise tax will apply. This planning opportunity creates another good argument for diversification rather than deferring exercise and sale.

Tax planning opportunities for stock options are highly dependent on future stock prices. Thus, planning should address more than a single or limited set of assumptions.

Karen Goodfriend, CPA/PFS is the principal at KK Wealth Advisers LLC. You can reach her at [e-mail].

BY KAREN GOODFRIEND, CPA