ISO portfolio planning issues.

Managing investments in any concentrated stock portfolio is challenging. When these portfolios include incentive stock options (ISOs), transactions require even more planning and careful analysis, as well as specialized knowledge.

The Basics

On the surface, ISOs are fairly simple: employers grant employees the right to buy company stock at some future period (typically from one to 10 years) at a pre-set price called the grant or strike price. The grant price usually approximates the stock's fair market value (FMV) at the grant date. If the FMV increases, employees would have a financial incentive to exercise their ISOs before the options expire and pocket the difference between the increased FMV and the grant price.

Unfortunately, complications arise due to the tax consequences of exercising ISOs. For ordinary Federal tax purposes, no tax consequences exist. However, the spread between the grant price and the FMV on the exercise date results in an alternative minimum tax (AMT) adjustment. If an employee sells the stock immediately after he exercises it, the tax and financial results are simple: the spread between the grant and exercise prices is treated as wages, taxed at the employee's marginal tax rate. Most public companies report these wages on the employee's W-2, and some have agreements with brokerage firms to withhold taxes.

Even though employees have a strong incentive to sell ISO stock for diversification, the Code gives them a reason to hold on to their ISO stock. Under Sec. 422(a)(1), if an employee holds the stock more than one year from the exercise date and two years from the grant date, the spread (and any appreciation since the exercise) would qualify for long-term capital-gain treatment at lower tax rates.

Employees pay large AMT balances on significant exercises of highly appreciated shares. They could claim a credit on the AMT attributable to the exercises if their regular taxable income exceeds their alternative minimum taxable income (AMTI) in later years. Therefore, the AMT that results from exercising ISOs is a tax prepayment of sorts, which employees can have refunded as an AMT credit when they sell their stock. This is because ISO stock has a different (and typically higher) basis for AMT than for regular tax purposes.

Example 1: Employee S exercises 1,000 ISOs with a cost or strike price of $20 per share, when the stock's FMV is $50. The AMT adjustment is $30 per share or $30,000. As a result, the stock's cost and tax basis are $20 per share, but the basis for AMT purposes is the FMV or $50 per share.

After holding the stock for one year, S sells it for $60. The regular tax gain is $40 per share ($60 in proceeds, less $20 basis) or $40,000. However, the gain for AMT purposes is only $10 per share ($60 in proceeds, less $50 basis) or $10,000.

In Example 1, the result is a negative basis adjustment for AMT purposes of $30,000 per share, and a corresponding decrease in AMTI. Assuming no other large AMT adjustment or preferences, regular taxable income will exceed AMTI, which results in an AMT credit against regular tax. In this simple example, it is likely the investor will get an AMT credit that will refund most or all of the AMT paid in the prior year.

Clearly, it is necessary to track the AMT basis and the AMT credit available, as well as the regular tax basis of ISO stock. When considering sales of ISO stock, planners and asset managers must consider the effect of the AMT gain or loss, in addition to the regular tax capital gain or loss.

The "Bear Trap"

During the extended bull market of the 1990s, holding ISO stock for a year or longer after exercise became the prevailing strategy. Significant price downturns were temporary and presented opportunities to exercise options at lower AMT consequences before the stock predictably recovered. Indeed, many high-tech employees with moderate incomes became unexpectedly wealthy as they held stock that appreciated wildly through numerous stock splits. Holding stock for the one-year holding period that was required for long-term capital-gain treatment seemed prudent. In addition, some employees were subjected to restrictive agreements that required them to hold stock for a specified time before selling it.

As a result, thousands of employees were trapped by the historic bear market that began in the spring of 2000. ISO holders who exercised at lofty price levels incurred large AMT tax bills. Expecting their company stock to continue appreciating, they held stock throughout the market downturn, waiting for prices to rebound. The well-publicized consequences were devastating for those holding stock that declined substantially in value. Two bills were introduced in Congress to provide relief to ISO shareholders, but neither was brought to a vote.

Those who survived the downturn still present their investment managers with challenges.

Example 2: The facts are the same as in Example 1, except the stock that cost $20 and was exercised at $50 is sold for only $30 per share. The regular tax gain on 1,000 shares is $10,000. However, S has a $20,000 loss for AMT purposes, because the AMT basis is $50 per share.

Unfortunately for S, the $3,000 capital-loss limit applies for AMT as well as regular tax purposes, restricting the AMT credit. As such, the credit will offset the capital-gain tax on the $10,000 gain, and roughly $3,000 of other income. Without the limit, however, the credit would have offset tax on $20,000 of capital gain. Thus, the majority of the credit may go unused.

One problem with unused AMT credits is the time value of money: a credit recouped years in the future is worth less than the original tax paid, due to forgone benefits on the tax amount. The delay in the credit can be especially painful if interest was paid on loans borrowed to pay the original tax. Further, AMT credits expire on death, eliminating any chance to get an AMT refund from the Federal government.

Getting Credit

From an ideal tax standpoint, S would want the stock to recover to $50 (the AMT basis) before selling, thereby recouping most or all of the AMT credit. However, this strategy is overshadowed by market uncertainty and cash-flow needs. Clearly, holding ISO stock requires careful fundamental evaluation of a company's long-term prospects.

Selling other securities at a gain can also release the AMT credit, because any AMT gain can be offset by an AMT capital loss. Effectively, the sale at a gain escapes taxation. The securities do not have to be ISO stock.

Many companies issue nonqualified stock options (NQSOs) in addition to ISOs. Unlike ISOs, NQSOs have an immediate regular tax consequence; the difference between the FMV at exercise and the option cost is included in an employee's income. If the exercise is significant, the employee's marginal tax bracket increases well above the 28% top AMT rate. The AMT credit will apply to all income taxed in excess of the AMT rate, effectively limiting the top rate to 28%. Exercising NQSOs to use an AMT credit must be weighed against the benefits of exercising them closer to expiration, including the risk protection of holding options rather than stock and the leverage provided by options appreciating without the need for cash investment.

To the extent that calculated regular tax exceeds AMT in any year, the credit is available to reduce the tax to the AMT level. Therefore, tax on additional ordinary income will be limited to 28% to the extent that suspended AMT credits are available. In addition, the applied AMT credit can be increased and taxes decreased by avoiding or deferring AMT adjustments and preferences.

Other Planning Considerations

Controlling risk. Investment managers and planners should take care to protect their clients from the devastating effects of depreciating ISO stock, especially if funds are later required to pay taxes or repay debt incurred while buying options. The use of strategic stop-loss market orders can help ensure that sufficient stock is sold to cover liabilities before the value drops to devastating levels. At the same time, the stop loss has no effect if the stock price appreciates.

Diversification is often hard to sell to employees who are loyal and have strong faith in their company's financial prospects. However, recent events have highlighted what prudent financial planners have been preaching for decades: broad diversification reduces risk, often without significantly sacrificing investment returns.

Selling ISO shares, especially after the holding period for long-term capital-gain treatment is satisfied, is also key to the strategy of recouping AMT. Option recipients who continually exercise and hold ISO shares run up compounding AMT bills that often need to be financed. Credits for previously paid AMT are not realized until tax events cause calculated AMT to be substantially less than regular tax. The best catalyst for releasing the credit is selling ISO shares. Assuming minor volatility in share prices, ISO sales can actually reduce taxes, by offsetting a 20% long-term capital gain with a 28% AMT credit.

Swapping. Some ISO plans allow the exercise of employee options by tendering employer stock that the employee already owns. This transaction is commonly referred to as a "stock swap" Typically, there are holding-period or other restrictions on stock used for the swap. The employee avoids gain recognition on appreciated stock used for the swap, and avoids the need to raise funds for the cost of the options. Because the transaction is treated as a like-kind exchange, taxes are not due on the exchange, and the basis in the shares that were swapped transfers to an equal number of the ISO shares received.

Example 3: Employee R owns qualified company stock with a basis of $10 per share, and wants to purchase 1,000 ISO shares with an option cost of $20 per share ($20,000 total cost) and a FMV of $50 per share. R swaps 400 shares (FMV $20,000) to pay the $20,000 option cost of the 1,000 shares. After the swap, he owns 400 shares with a carryover basis of $10 per share.

In Example 3, the additional 600 shares carry no basis (assuming no cash was used in the transaction). Note: Any subsequent sales are deemed to come from the 600 shares with no basis, before any sales occur from the shares with the carryover basis.

Exercise timing. There is often a benefit to scheduling unusually large ISO exercises in the first 100 days of the calendar year. This allows the option stock to satisfy the one-year holding period for long-term capital gain treatment before the AMT tax balance is due on April 15th of the following year. (This assumes the taxpayer is otherwise penalty-proof in the year of exercise.)

Proposed regulations. This final item adds additional complication to already difficult planning. The IRS has issued proposed regulations (REG-142686-01) under which an individual who exercises ISOs will realize wages for FICA and FUTA, but not for income tax withholding, purposes. The proposed regulations will require employers to withhold Social Security and Medicare taxes on employee ISO exercises starting in 2003. This may require option holders to fund payroll taxes or sell a portion of the resulting stock (in a disqualifying disposition) to pay their portion of the taxes. The taxes can be avoided by exercising the options before 2003.

Author:
James "Chip" Dennedy,
CPA, PFS, CFP
Senior Accredited Financial Planner
REDW-Stanley
Financial Advisors, LLC
Albuquerque, NM