NQSO strategies - avoiding past mistakes.

With a prolonged bear market And a slide in technology stock prices, employee stock options have lost much of their luster. When the technology bubble burst, many employees who had exercised options learned a painful lesson. Although this popular form of compensation generated significant wealth for many, it also threatened others' financial security. By not anticipating the tax consequences and risks of various strategies, this potentially valuable asset became a liability. This article focuses on the tax treatment of nonqualified stock options (NQSOs) and some NQSO strategies that can avoid unsavory tax consequences. (For a discussion of incentive stock options (ISOs), see Dennedy, Personal Financial Planning, "ISO Portfolio Planning Issues," TTA, July 2002, p. 459.)

Past Blunders

Many stock option holders who took risks in the 1990s did not consult tax advisers and were unaware of some tax and economic consequences of their actions. As taxpayers were filing their 2000 returns, dramatic stories of insolvent taxpayers owing alternative minimum tax (AMT) as a result of exercising their ISOs unfolded in the media.

Example 1: In early 2000, M exercised 10,000 ISOs for $20 per share when her employer's stock peaked at $100 per share. By year-end, the technology stock was worth $5 per share; M continued to hold the stock. In April 2001, she discovered that in addition to being out-of-pocket $20 per share for the exercise price, she owed AMT tm the $800,000 spread on exercise (($100 stock fair market value (FMV)--$20 ISO exercise price) x 10,000).When M finally sold the stock in May 2001 for $1 per share, she recovered only $10,000 and owed more than $200,000 in AMT.

Had M sold the stock when she exercised the option, she would have made a huge profit. Unfortunately, a same-day sale probably had little appeal to M at the time. M undoubtedly believed the stock price would rebound, and focused instead on the primary tax advantage of ISOs--long-term capital gain treatment. M held the stock for one year, without considering whether the price would decline or whether she would owe AMT. There was no withholding on exercise and M, like so many others, had no funds set aside to cover the liability.

Dissimilar Vehicles

While most of these tales of woe involved ISOs, NQSOs pose similar risks. Employees who exercise NQSOs and dare to hold the stock in anticipation of value increases and long-term capital gain tax benefits, expose themselves to a risk greater than that of ISOs. NQSOs are potentially subject to a higher tax prepayment risk, because their spread at exercise is taxable at ordinary rates (usually higher than AMT rates).

Many taxpayers are unaware of this and become tempted by today's lower capital gain rates. The lessons of the 1990s were so dramatic that taxpayers cannot always appreciate that even a less volatile stock market poses risks to strategies that maximize capital gains.

NQSOs differ from ISOs in several important ways:

* For NQSOs, there is withholding on exercise.

* Unlike ISOs, NQSOs may be in-the-money when granted (i.e., the stock's FMV exceeds the exercise price).

* NQSO gain is taxable as compensation on exercise. By contrast, for regular tax purposes, ISO gain is taxable when the taxpayer sells the stock.

* Unlike ISO gain, NQSO gain is not eligible for long-term capital gain treatment, except for stock appreciation after exercise. Accordingly, NQSO gain on exercise is taxable at the highest marginal late.

* For NQSOs, AMT treatment mirrors regular tax treatment, so AMT is not an inherent planning consideration. For ISOs, however, the spread at exercise is subject to AMT, a major consideration.

* Because NQSOs are not tax-favorable, the, they tend to have more flexible terms than ISOs.

Future Prospects

The inevitable reappearance of positive stock market returns and business success stories will once again lead to executives and employees focusing on the value of their options. Along with that, the Jobs and Growth Tax Relief Reconciliation Act of 2003 increased the potential tax benefits of adopting stock option strategies that generate capital gains, by increasing the spread between the top ordinary income tax rate and the capital gain late from 18.6% to 20%, which, if only slightly, will increase the incentive for maximizing capital gains. As stock prices rise, more employees with options will be asking whether and when to exercise options or sell stock.

NQSOs and the Mature Company

An effective approach to the risks and rewards of NQSOs depends first on whether a taxpayer is employed by a mature company of a startup.

Example 2: T is employed by V, a large, established Silicon Valley software company; he wants to reduce the taxes on his NQSOs. Four years ago, V granted him 62,000 NQSOs exercisable at $7 per share, when the stock was selling for $10 per share. A year ago, the stock was worth $70, but it is now worth $50. V granted the NQSOs with a built-in bargain element on the grant date. As is typical, T's NQSOs lacked a readily ascertainable FMV (as narrowly defined in Sec. 83) and were not taxable on the grant date.

T believes his V stock will rebound to its previous price and wants to take advantage of long term capital gain rates or a the appreciation. He assumes the stock will rise to $70 again. T has a choice of three strategies: exercise and sell (same-day sale); delay exercise; or exercise and hold.

T's potential capital gain benefit is limited to the post exercise stock appreciation. T would recognize compensation income of $43 per share on exercise; his cost basis will equal the FMV as of the exercise date ($50). T's strategy has potential benefits and risks.

More to lose than to gain. Exhibit 1 on p. 629 presents the potential outcome and risks of the three strategies, which depend on timing and the stock price on the sale date. It compares the net value realized as of the end of the second year, by incorporating the proceeds from the stock sale, total taxes paid and, in the case of a buy-and-hold strategy, the opportunity cost to finance the exercise price and tax withholding. For a same-day sale in the first year, it includes investment returns for one year. Exhibit 2 on p. 630 shows the net cashflows. The exhibits assume the following facts:

* There are 62,000 NQSOs at a $7 exercise price;

* Ordinary income from exercise is taxed at 42.5% (top Federal and state rates, plus Medicare);

* T resides in California, with a top marginal rate of 9.3%;

* Capital gains are taxable ac 24.3% (15% Federal late, no state tax deduction due to AMT); and

* If the funds were invested instead of being used to finance the purchase, the after-tax return would be 6%.

[GRAPHIC OMITTED]

If the stock appreciates 40% (to $70 per share) during the one-year period following the exercise date, the strategy of exercising and holding to generate long-term capital gain provides approximately $140,000 net cashflow savings, compared to delaying exercise one year and then selling the same day ($2.385 million vs. $2.246 million). The delay-exercise strategy generates compensation income taxed as ordinary income at higher rates, although there is no cost to finance the exercise.

With a 40% decline in stock value, T has more to lose than he would have gained, as the total amount realized with an exercise-and-hold strategy is only $207,000, compared to a delayed exercise and same-day sale at the same price, yielding $820,000. The exercise-and-hold strategy yields $613,000 less cashflow to T.

Despite the post-exercise decline in stock value, T has to pay tax on unrealized ("virtual") gain on the stock's value at exercise, plus the cost of financing the exercise and withholding. In addition, the subsequent capital loss 11 [pounds sterling] the stock sale (absent offsetting capital gains) results in a large and currently unused capital loss carryover of about $1.2 million. This risk-reward proposition makes it difficult to justify an exercise-and-hold strategy.

Because taxes are withheld initially, the exercise-and-hold strategy may be more expensive with NQSOs than ISOs if the stock price declines. Also, if the stock value drops after exercise, an NQSO offers no opportunity to "undo the damage" before the end of the tax year. Under Sec. 56(b)(3), an ISO stock sale made in the same tax year that the ISO was exercised eliminates AMT gain; a sale within one calendar year of" exercise limits compensation income for regular tax purposes to the stock's sales price, minus its adjusted basis, according to Sec. 422(c) (2). This bailout is not available to NQSOs.

For mature companies, taxpayers should avoid exercising and holding, which is a tax-minimization strategy, and should focus instead on a wealth-preservation strategy, by either executing a same-day sale or delaying exercise until a sale is contemplated.

The same-day sale approach avoids a tax-prepayment risk. Although the exercise-and-hold approach may result in a relatively small tax savings, it overshadows the reward (as demonstrated in Exhibit 1).

Substantial risk of forfeiture. If stock acquired on an NQSO exercise is nontransferable and subject to a substantial risk of forfeiture, Sec. 83(a) applies to the NQSO stock (not to the option). The gain is deferred until the stock restrictions lapse.

Example 3: The Facts are the same as in Example 2, except T exercises the options when the stock is worth $50, but the stock is restricted until he fully vests by completing one more year of employment. He must return the stock to the company if he leaves the job before then. T expects the stock to be worth $70 when he vests.

How do the facts in Example 3 charge the analysis? Sec. 83(a) delays ordinary income recognition until the stock vests; if the stock is worth $70 on vesting, the entire spread of $63 ($70-$7) per share is ordinary income on the vesting date.

Alternatively, T could make a Sec. 83(b) election to recognize the spread on exercise as ordinary income immediately. T would have compensation income of $43 per share in the current year; the balance would be capital gain when he sells the stock.

However, risk increases with the Sec. 83(b) election. If T made the election to recognize $43 ($50-$7) per share of compensation income on exercise and subsequently forfeited the restricted stock (with the company returning his S7 exercise price), then T's deductible loss on forfeiture would be zero, despite the $43 of income previously recognized; see Sec. 83(b)(1) and Regs. Sec. 1.83-2(a). The Sec. 83(b) election is exceptionally risky when the spread at exercise is large, particularly if forteiture is likely.

NQSOs and Startups

Strategies for startup NQSOs vary from those for mature companies. Before establishing a going-concern business, stock value is quite low for most startups. A cash-poor startup may rely heavily on stock options to compensate employees; the delayed vesting of the stock provides an incentive for employees to stay with the new company. Unlike the taxpayer in Examples 2 and 3, whose Sec. 83(b) election was extremely risky, an employee of a startup company who fails to make the election may lose the opportunity to reduce taxes significantly if the company is later successful. The exercise spread is often insignificant, but the possibility of tremendous post-exercise stock appreciation is great.

Example 4: J joined a biotechnology startup, B, that plans to have an initial public offering (IPO) pending FDA approvals. B grants 100,000 NQSOs, for which the underlying stock will vest annually over the next four years. J can exercise her options prior to the stock vesting, subject to a buyback by B at the exercise price if J quits early. J must remain employed by B for the stock to vest. The option's exercise price and. the stock's current FMV are $1 per share. 13ccauseJ can exercise her options before the stock vests, she can either (1) exercise and hold of (2) delay exercise until vesting and hold or sell at that time.

The exercise-and-sell strategy is impractical, because the options are not vested. J has an incen6ve to exercise the NQSOs before the stock value rises and to make a Sec. 83(b) election for all of the restricted stock received; this will ensure capital gain treatment on subsequent appreciation. However, she must exercise the NQSOs (and receive the restricted stock) before she can make the Sec. 83(b) election.

Delaying exercise postpones the need to pay out the exercise price; however, the stock value may increase in the interim. As the stock price climbs and the spread widens before an employee exercises the NQSOs, the Sec. 83(b) election becomes less desirable. If J is vested in the stock when she exercises the NQSOs, the spread is ordinary compensation income without the alternative of the Sec. 83(b) election.

In Example 4, if J exercises all of her options when the stock value equals the $1 exercise price, the stock's cost basis will then be $1 per share; subsequent appreciation is treatable as capital gain if she makes a Sec. 83(b) election.

Example 5: The facts are the same as in Example 4; the IPO is successful and the B stock soars to $50 per share when the stock is sold at the end of year 4. J's $4.9 million gain is taxable as long-term capital gain, yielding roughly a $900,1100 tax savings (assuming the combined Federal and California effective rate on ordinary income, including a Medicare tax, is 42.5%, versus a 24.3% capital gain tax).

However, if the stock becomes worthless, two possibilities would emerge: J forfeits the stock before it vests and gets her exercise price back from B (zero gain or loss); or B goes out of business or the stock becomes worthless before J can sell it and she loses her $100,000 investment--a capital loss of $1 per share. Although the potential rewards are great, an employee must be willing and able to risk the full amount of the exercise price. Over the years, most startups have failed; recently, this has been the destiny of many high-tech startups, especially those Internet-related.

Conclusion

Various NQSO strategies have different risk levels. The strategy with the least risk and potentially highest tax is a same day sale. An exercise-and-hold strategy carries an investment risk (the amount paid to exercise the option), along with a tax-prepayment risk. The most problematic case for an exercise-and-hold strategy often involves a mature company, in which the spread on exercise can be large. The tax law adds a significant prepayment risk that dampens the upside, and capital loss limits that magnify the downside.

Exhibit 1: T's NQSO strategies
62,000 shares @ $7 exercise price
Current FMV: $50

                                                     FMV in 1 year
                                                          $50

1. Exercise and hold for one year:

Exercise cost                                        $   (434,000)
Tax on exercise @ 42.5% effective rate               $ (1,133,050)
Cost of funds, one year: exercise cost @ 6% *        $    (26,040)
Cost of funds, one year: tax withholding
  37.75% @ 6% *                                      $    (60,385)
Sell shares after one year @ FMV                     $   3,100,000
Tax on capital gain (FMV--$50 @ 24.3%) **            $          --
Net cashflow after one year                          $   1,446,525
  Capital loss carryover
  (to offset future capital gain/$3,000
     per year)

2. Exercise after one year, with
   same-day sale:

Exercise cost                                        $   (434,000)
Sale proceeds                                        $   3,100,000
Tax on exercise @ 42.5% effective rate               $ (1,133,050)
Net cashflow after one year                          $   1,532,950

3. Exercise now, same-day sale and diversify:

Net cashflow after sale                              $   1,532,950
Annual 6% after-tax return                           $      91,977
Net cashflow after one year                          $   1,624,927

                                                     FMV in 1 year
                                                          $70
1. Exercise and hold for one year.

Exercise cost                                        $   (434,000)
Tax on exercise @ 42.5% effective rate               $ (1,133,050)
Cost of funds, one year: exercise cost @ 6% *        $    (26,040)
Cost of funds, one year: tax withholding
  37.75% @ 6% *                                      $    (60,385)
Sell shares after one year @ FMV                     $   4,340,000
Tax on capital gain (FMV--$50 @ 24.3%) **            $     301,320
Net cashflow after one year                          $   2,385,205
  Capital loss carryover
  (to offset future capital gain/$3,000
     per year)

2. Exercise after one year, with
   same-day sale:

Exercise cost                                        $   (434,000)
Sale proceeds                                        $   4,340,000
Tax on exercise @ 42.5% effective rate               $ (1,660,050)
Net cashflow after one year                          $   2,245,950
3. Exercise now, same-day sale and diversify:
Net cashflow after sale                              $   1,532,950
Annual 6% after-tax return                           $      91,977
Net cashflow after one year                          $   1,624,927

                                                     FMV in 1 year
                                                           $30

1. Exercise and hold for one year:

Exercise cost                                        $   (434,000)
Tax on exercise @ 42.5% effective rate               $ (1,133,050)
Cost of funds, one year: exercise cost @ 6% *        $     (26,040
Cost of funds, one year: tax withholding
  37.75% @ 6% *                                      $    (60,385)
Sell shares after one year @ FMV                     $   1,860,000
Tax on capital gain (FMV--$50 @ 24.3%) **            $          --
Net cashflow after one year                          $     206,525
  Capital loss carryover                             $ (1,240,000)
  (to offset future capital gain/$3,000
     per year)

2. Exercise after one year, with same-day sale:

Exercise cost                                        $   (434,000)
Sale proceeds                                        $   1,860,000
Tax on exercise @ 42.5% effective rate               $   (606,050)
Net cashflow after one year                          $     819,950
3. Exercise now, same-day sale and diversify:
Net cashflow after sale                              $   1,532,950
Annual 6% after-tax return                           $      91,977
Net cashflow after one year

* Opportunity cost on funds otherwise invested at a 6%
after-tax return.

** Rate assumes taxpayer is in Federal AMT from capital
gain.

Karen Goodfriend,

CPA/PFS, CFP

Partner

Goldstein Enright

Menlo Park, CA

Gary R. McBride, Esq., CPA

Professor of Accounting

California State University, Hayward

Hayward, CA