Recipients of Stock Options Need to Know Tax Issues.

IN this volatile stock market, the legions of MOPs (millionaires on paper) and ex-MOPs are growing by the day. In this climate, executives who hold stock options and other forms of equity compensation need to develop at least a basic awareness of the key tax issues. The only thing worse than a huge tax bill on the exercise of a highly appreciated option position is any tax bill at all on a paper fortune that has evaporated.

In any market, equity compensation makes good sense for companies. It allows companies to reward employees without spending precious cash (or having a substantial effect on earnings), aligns employees' economic interests with those of the company and, under a vesting schedule, provides "golden handcuffs" to keep key employees on board. It also can generate a big cash-free income tax deduction for the company -- even allowing some major corporations to avoid corporate tax altogether. However, in this market -- where overnight multimillionaires have seen their fortunes dry up before their "lock-ups" expire -- employee enthusiasm for non-cash compensation may be on the wane. The more traditional view that equity is merely a "kicker" to an executive's cash compensation package appears to be making a comeback.

For those executives who are negotiating a new compensation package or renegotiating an old deal after a market "correction," the basic tax goals relating to the equity component are: deferring the accumulation of taxable income for as long as possible, minimizing capital gains taxes on the sale of the equity stake, preserving flexibility for future estate planning and minimizing the economic risk from undertaking any tax-planning strategies.

Often, there are tradeoffs in pursuing these goals. However, as with most things, the stronger your bargaining power, the better your chance of obtaining a custom compensation package that can achieve most of these goals. At the very least, a well-designed package can preserve your ability to choose among these goals, based on your needs at a particular time.

There are five basic types of equity compensation: restricted stock, non-qualified options (non-ISOs), incentive stock options (ISOs), phantom stock or stock appreciation rights (SARs), and non-stock equity, such as LLC or partnership interests. Each is taxed differently. We highlight only the most basic rules below, but recommend that advisers be consulted for sophisticated tax strategies.

* Restricted Stock. The difference or "spread" between the value of the stock and its purchase price, if any, is considered compensation income -- not capital gains -- when the stock "vests." It is advisable when dealing with this kind of stock to file a special "election" document -- known as an "83(b)" election -- with the IRS at the time of the award of unvested stock in order to lock in capital gains on future appreciation or avoid income tax entirely if the stock is held for life.

* Non-ISOs. The spread between the value of the underlying stock and the option exercise price is considered compensation income at the time the option is exercised. The special 83(b) election cannot be made on the option, but can be made on unvested stock received when the option is exercised. Therefore, early exercise of the option, and filing the special 83(b) election should be considered.

* ISOs. The spread between the value of the underlying stock and the option exercise price is not subject to regular tax at the time the option is exercised, but is subject to the "Alternative Minimum Tax" (AMT). If stock is held fur inure than one year after the option is exercise, all gains on the sale above the exercise priceexercised, all gains on the sale qualify as capital gains, and any tax previously paid under the AMT is generally creditable against the capital gain tax. ISO stock needs to be watched carefully after exercise. If there is a market collapse, the AMT tax can be avoided by selling the stock in the same year as you exercise the options.

* Phantom Stock/SARs. Cash or the value of stock withdrawn from the employee's account is considered compensation income at the time of withdrawal. These are good vehicles because no economic outlay is required, but generally do not provide good opportunities for capital gain (or avoidance of income tax through lifetime retention). Therefore, this compensation arrangement is not considered optimal.

* LLC and Partnership Interests. The grant of a "mere profits interest" is not taxable. If there are no immediate rights to LLC or partnership capital upon liquidation and no certain prospects for future income, then the interest probably is a mere profits interest. Huh? A "protective" special election is generally advisable. "profits" interest only (as opposed to an immediate interest in a capital account) is not taxable. An 83(b) election makes sense if the interest is unvested, to protect against tax at the time of vesting.

Even this cursory review suggests some general principles and planning opportunities. Options are most desirable (and have become the dominant form of equity compensation) because they permit the executive to defer both the economic risk and the taxable income until exercise. However, deferral comes at the price of a compensation tax (not capital gain) on all of the appreciation in the underlying stock until the option is exercised. An executive or his advisers can run pro forma calculations to estimate the effects of this trade-off. Incentive stock options (ISOs) are generally good, but in this market, holding stock options for better capital gains treatment can be a very risky proposition. LLC profits interests are also good vehicles.

Without good tax planning at the time an executive negotiates a compensation package, the executive can later find himself or herself with a huge paper gain that is eaten up by taxes.

Executives who are entering into negotiations should extensively educate themselves on tax matters or should seek the advice of counsel or consultants who are experts in these matters. It often makes sense to seek the representation of counsel that can integrate the business and tax negotiations.sold.

Menasche Nass and Andrew Bernknopf are attorneys with De Castro, West, Chodorow, Glickfeld & Nass, Inc.

Entrepreneur's Notebook is a regular column contributed by EC2, The Annenberg Incubator Project, a center for multimedia and electronic communications at the University of Southern California.