Sunk by options.

How to avoid stock option tax catastrophes.

Only a little more than a year ago it seemed that stock options were the quick path to riches. After all, the stock market seemed to be defying the laws of gravity: Everything was going up--and staying up. Then the steep market downturn rudely reminded option holders that the popular form of equity compensation is not an automatic money machine. Many learned to their dismay not only the high cost of failing to appreciate investment risks but, even worse, how the tax laws conspire to double the penalty.

BLISSFUL IGNORANCE

Unfortunately, many rank-and-file workers--and more than a few top executives--are blissfully ignorant of the perils of stock option ownership. A study by Oppenheimer Funds of option holders indicated 37% knew very little about the tax implications, investment and market risks. "Many employees don't really comprehend what they have been granted when they're given stock options," says Barbara Steinmetz, president of Steinmetz Financial Planning in Burlingame, California.

"They know this is something they should take advantage of, but they don't know the kind of option they've got or even where it fits in with their personal investment goals," she says. "I've seen people who were shell-shocked when the tax bill arrived, and to pay Uncle Sam they're suddenly forced to sell the stock they had exercised. But when they went to sell that stock they found the value had dropped like a rock."

Take the case of Internet Capital Group, a venture capital holding company that lent $76 million in the summer of 1999 to employees wanting to exercise stock options on some 33 million shares. The company went public in August 1999 at $12 a share, reaching as high as $150 in January 2000. Employees who had exercised their stock options after borrowing heavily from the company figured they had struck the mother lode and spent accordingly--buying expensive cars and homes. Then the stock started falling, hitting a nadir of about $2 in May 2001. To pay their loans some had no choice but to sell the stock at basement prices. At last report, some $52 million in loans was still outstanding.

SETTING FREE THE BEARS

Lower stock values and higher debt loads have made life miserable for many option holders. But ignorance is as much a culprit as Wall Street uncertainty or greed.

"Not only are the rank-and-file in the dark about options," says financial planner Steinmetz, but "I've seen people at the top of their companies who are clueless. People should be banging on the doors of their companies, accountants and financial planners begging for help."

However, many companies that grant stock options are leery about providing this guidance. "They don't want to be construed as giving investment advice to their employees about their own stock," explains Mike Kesner, CPA, a partner-in-charge of the executive compensation practice at Arthur Andersen, LLP, in Chicago. "If the stock goes south, that could raise a hornet's nest of [legal] trouble [for the company]." While some companies hand out educational brochures and sponsor seminars on options, these activities usually occur when the options are granted, which may be several years before an employee elects to exercise them. Since most options have a 10-year tenure, much of what they learned is usually forgotten.

Options are intended to be a win-win choice for employers and employees, which is why they're the single most common form of equity compensation. Employers, for example, receive a tax deduction for the year in which some types of options are exercised (more on this later). Granting options instead of forking over more cash compensation to workers also helps companies keep salaries in check. Meanwhile, employees are motivated to become more productive since they now have a financial stake in the company.

A GREAT DEAL

Options also are seen as a way for companies to attract and retain higher quality employees. Certainly, if not grossly mismanaged, options are a great deal. Employees basically are given the right to buy stock over a specified period (typically 5 to 10 years) at a pre-set price. If the market price is higher at the time the employee exercises the stock, he or she can pocket the difference (called the spread) by selling right after the exercise. Many employees who did just that--before the stock market sputtered--reaped a windfall.

Others, of course, came too late to the party. Or they exercised early enough, but due to restrictions of the tax law could not sell right away and watched the value of their holdings plunge.

There are two types of stock options--incentive stock options (ISOs) and nonqualified stock options (NSQs)--each with its own risks and tax treatment. While as a rule both avoid any tax implications at the time of granting or during the vesting period, ISOs and NSQs go their own way, taxwise, upon exercise.

NSQs are treated as ordinary income for tax purposes at the time of exercise, assuming the fair market value at exercise is higher than the option price (a positive spread). For example, if the option price is $10 a share and, at the time of exercise, the market price is $50, the taxable income is $40, and it's subject to withholding.

If the stock is later sold, there is a capital gain or loss for the amount above or under the $50 fair market value on the date of exercise. The employer, meanwhile, receives a tax deduction at the time of exercise based on the difference between the exercise price and the fair market value.

Sounds pretty simple. The problem is that many employees fail to appreciate the tax consequences of the stock at the time of exercise, since they pay only the exercise price and not the real market price (as in the previous example, $10 a share paid vs. $50 a share). The spread carries significant tax ramifications, forcing the employee to come up with money to pay the extra tax burden.

"Come tax time they may need to cash in some of the stock to pay the bill," says financial planner Steinmetz. "That's okay, unless the stock has tanked in the interim."

Although employers withhold federal taxes on the exercised option at a 28% rate, some employees enter a higher tax bracket (that is, 38.5%) because of the value of the exercised options. But since these individuals are not required to pay quarterly estimated taxes, they are hit with a sizable tax bill come April 15, Steinmetz says. "I had a young client who thought he owed $2,500 to the IRS," Steinmetz recalls, "but the infusion of money he received in the form of the exercised options put him in a much higher tax bracket than 28%, and on April 13, the day all this became apparent to me, I told him he didn't owe $2,500; he owed $11,000."

PAY THE BILL

What could be done to ease the pain? After the fact, not much, says Andersen's Kesner. "About all he could do was negotiate an installment payment schedule with the IRS or get a loan to pay the bill." The taxpayer ultimately did the latter, borrowing the sum from his grandmother.

Some employees dig an even deeper hole, borrowing against the option profit (a practice called a margin loan). The Wall Street Journal reported recently that 25 Microsoft employees had filed for bankruptcy when the stock options they exercised were hit by Microsoft stock's 50% decline since the late nineties.

"Apparently some of these employees had borrowed against the perceived value of their options as a down payment on some very expensive houses," says Alan Ungar, president of Financial Counsel Inc., a Calabasas, California-based financial planning firm. When the tax bill came, they needed to borrow again, Ungar adds. They then found that the bills on the loans were more than their regular income could support and consequently had to sell the stock, which had fallen precipitously in value. Ultimately, there was no place left to go (other than to bankruptcy court).

Although a capital loss from the stock upon sale would offset any capital gains, Kesner says this recourse is available only if there are capital gains. For example, if the exercise price of an NSQ is $10 and the fair market value at that time is $50, the option holder picks up $40 per share in ordinary taxable income. But say the stock drops the next year to $25 a share and the employee decides to sell it. That would represent a $25 per share capital loss, which could be offset by any capital gains. Without capital gains, the taxpayer is out of luck. Not only did he or she pay income taxes on that $25 per share the previous year--which is substantial for those in the 40% tax bracket--but this year he or she can't deduct the capital loss--except for $3,000, the amount allowed by law in excess of any capital.

While little could have been done post-exercise under this scenario, hindsight reveals the mistakes that fostered the problem. "Exercising an option and using it as collateral for borrowing only makes sense if the stock goes up, which it doesn't always do--even though in the nineties it seemed a God-given inevitability," says Tim Kochis, president of Kochis Fitz, a San Francisco-based wealth management firm.

Needless to say, this strategy is only for the sophisticated and well-heeled who can afford to take the risk; not the rank and file. "Unfortunately," says Kochis, "some got caught up in the irrational exuberance that characterized the latter part of the decade."

EVEN DICIER

From a tax complexity standpoint, NSQs are simple compared with ISOs, which present a veritable thicket of entanglements. When an ISO is exercised, the spread typically is subject to alternative minimum tax. The AMT (between 26% and 28% of the positive value of the spread) allows the option holder to avoid paying ordinary income tax on the exercise, which arguably will be higher than 28%. If the taxpayer holds on to the exercised option stock for more than a year and then sells it, the income is treated for tax purposes as capital gains--at a maximum rate of 20%.

The incentive (hence the term incentive stock options) is obvious: The longer the ISO stock is held, the lower the tax cost. The risk, of course, is that the stock value may plunge during the one-year holding period.

Another perceived drawback is that even though the payment of AMT may create a tax credit in the future, it still amounts to a tax prepayment on a holding that later may be virtually worthless.

Explains Ungar: Say you exercised ISOs when the value of your company's stock was substantially higher than the exercise price. While the exercise didn't affect your regular tax liability, you did have to pay an additional $100,000 in taxes because of the AMT. However, you were granted a future tax credit of $t00,000, which you can claim to the extent your ordinary tax exceeds your AMT. But, instead of rising in price, the stock drops substantially and is now worth less than what you paid to exercise the options. You sell the stock for less than the exercise price, realizing a loss. But because your ordinary income tax liability is only $5,000 more than your AMT liability, you can apply only $5,000 of the $100,000 tax credit. The upshot is clear. If the difference between your ordinary tax and AMT liabilities remains $5,000, it will take you 20 years to recover the overpaid tax.

"You have essentially prepaid far more than is ultimately owed, and it will take you decades to recover what has now become a gross overpayment," says Ungar. "This is not what Congress had in mind when it crafted the AMT in 1986. It saw it as a prepayment of a tax to be paid later, not the imposition of an additional tax."

Ungar advocates reform legislation that would make the minimum tax credit fully refundable when the stock is sold, thus permitting the taxpayer to recovery fully any overpaid tax. (For more on this effort, log on to www.ReformAMT.org).

GIVING ADVICE AND COUNSEL

What can companies do to protect their option holders? Harvard Law School professor Christine Jolls, who has been studying stock options for the past year, says employers, financial planners and accountants must make a concerted effort to clear up the confusion. From a fiduciary standpoint, it is acceptable to explain to employees what happens taxwise under each of several different option exercise and sale scenarios, she says.

Not all companies do that, however. "Some companies and advisers--and shame on them--have handed out options to their mailroom clerks with no explanations whatsoever," says Peter Elinsky, CPA, national partner-in-charge of compensation and benefits in the McLean, Virginia, office of KPMG, LLP. "They might hand out this thick brochure solely for upper-echelon executives without understanding the special needs of lower-level employees. These people are being blindsided."

So what's the answer?

Ungar advises clients "to first identify their critical capital needs--that is to pay all your bills through your working life and your retirement--before giving a thought to stock options." If you want to reach this critical capital benchmark in 10 years, he explains, you're not going to want to have all your financial eggs in one basket. "You might take some of the risk out of your options by exercising a few and immediately selling the stock, paying the taxes and reinvesting the proceeds in other stocks and wealth-building assets," he says.

Ungar has even developed a Web site, www.MyCriticalCapital.com, to help option holders define their critical capital needs.

Kochis advises patience when exercising options. "The general rule is don't rush," he says. "You have up to 10 years in most cases. Wait until the options are about to expire, when the opportunity to buy cheap is about to run out, and then exercise. During this time, financial advisers can help you develop a strategy."

As for the tax ramifications of exercising options, Elinsky of KPMG recommends immediate sale upon exercise, particularly if they're ISOs. "While it may be tempting to hold on to the stock for more than a year to obtain a lower capital gains tax rate, that requires putting up cash to cover the AMT and absorbing the risk that the stock will go up a year later," he says. That is not a sound strategy. Taxes, he contends, should be a secondary consideration in determining when to exercise a stock option, despite the inducement to reap a lower rate.

In short, he says, be sure you don't let the tax tail wag the economic dog.

Options on the Rise

The number of nonexecutive employees who receive stock options as part of their compensation has more than doubled in the last four years to 5.5 million. In all, more than 10 million people now hold stock options, up tenfold since 1992.

Source: The National Center for Employee Ownership, www.nceo.org.

EXECUTIVE SUMMARY

* STOCK OPTIONS, OFTEN A QUICK PATH to riches, can become a costly burden if the stock market tumbles and the instruments are handled incorrectly--a combination of events that both executives and rank-and-file workers have recently experienced.

* MANY OPTION RECIPIENTS ARE blissfully ignorant of the investment and tax-related perils of stock option ownership, and many of them face huge income tax liabilities as a result.

* COMPANIES THAT GRANT STOCK OPTIONS may be leery about providing this guidance for fear of legal troubles, if the stock falls.

* THERE ARE TWO TYPES OF STOCK OPTIONS--incentive stock options (ISOs) and nonqualified stock options (NSQs)--each with its own risks and tax treatment. While as a rule both avoid any tax implications at the time of granting or during the vesting period, ISOs and NSQs go their own way, taxwise, upon exercise.

* WHAT CAN COMPANIES DO TO PROTECT their option holders? One suggestion: Be sure employees are told the tax consequences.

* OPTIONS HOLDERS ARE ALSO ADVISED not to keep all their financial eggs in one basket. They should remove some of the risk by exercising a few and immediately selling the stock, paying the taxes and reinvesting the proceeds in other stocks and wealth-building assets.

* ANOTHER ADVISER ADVOCATES PATIENCE. In most cases, investors have up to 10 years to act, so they should wait until the options are about to expire, when the opportunity to buy cheap is about to run out, and then exercise.

RUSS BANHAM is a journalist and author. His most recent book is Rocky Mountain Legend, a biography of the Coors brewing dynasty. He is at work on a 100-year history of the Ford Motor Co. Banham lives in Seattle and Missoula, Montana. His e-mail address is [e-mail].