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Stock Option Strategies
This information was graciously provided by Jim Marucci of Ernst & Young LLP, who isn't responsible for anything you do with it (see our disclaimer).
The outline format is due to its former life as a PowerPoint presentation.STOCK OPTION STRATEGIES
Overview of Non-Qualified (NQ’s) and Incentive Stock Options (ISO’s) Planning Considerations Exercise Techniques Estate Planning Techniques WHY STOCK OPTIONS?
Employee must generally place his/her own money at risk. Shareholders gain when employee gains No earnings charge to company Tax deductible to employer (Non-qualified) Company receives cash for its stock TYPES OF OPTIONS
NON-QUALIFIED STOCK OPTIONS INCENTIVE STOCK OPTIONS NON-QUALIFIED OPTIONS
No income tax liability at grant. Considered "Compensatory Income". Upon exercise, the difference between the grant price and the fair market value (bargain element) is taxable as ordinary income. The company receives an income tax deduction on the amount the employee takes into income. Withholding taxes are due on or about the exercise date. NON-QUALIFIED STOCK OPTIONS
Sale after exercise generates capital gain or loss Sold before 12 months - Ordinary income tax rates Sold after 12 months, before 18 months - 28% Sold after 18 months - 20% Stock cost basis after exercise = FMV at exercise date. Exception - Exercising with stock (Pyramiding) INCENTIVE STOCK OPTIONS (ISO)
The option must be exercised within ten years of grant date (5 years for > 10% shareholders) Must have a price of at least the stock’s FMV on date of grant, (110% of FMV of stock for a more than 10% shareholder) The option must not be transferable, except by death. INCENTIVE STOCK OPTIONS
Option Plan Requirements -
Specify the number of shares that may be issued. Specify the employees or class of employees eligible for awards. Shareholder approval. Limit each executive to an annual exercise value of $100,000 worth of stock. The option grant must be made within ten years. INCENTIVE STOCK OPTIONS
Exercise Provisions -
Must be made no later than three months after termination. Sale or disposition of stock must meet holding period requirements in order to avoid disqualification: Sale must wait until two years after option is granted, AND one year after option is exercised. PLANNING CONSIDERATIONS
Vesting Requirements Holding Period Requirements How to Pay for the Option SEC Rules Tax Impact VESTING REQUIREMENTS
Vesting - The period of time that must elapse before an option is eligible to be exercised. Options generally expire as follows: 10 years after grant 3 months after retirement or permanent disability 1 year after death HOLDING PERIOD
IRS Requirements for Capital Gain Treatment: Sale of Stock Must Take Place Greater than: 1 Year after Exercise, AND 2 Years after Date of Grant There may be additional requirements from the company, such as "Years of Continuous Service". PURCHASE METHODS
Options can be exercised with: Personal Funds
Best when dividends plus appreciation equal or exceed returns on present investments. Borrowed Funds
Best when dividends plus appreciation exceed after-tax cost of borrowing. Other Options (Cashless) Personally Held Company Shares (Swap)
Best when returns on present investments + borrowing costs exceed dividends and projected appreciation of the stock. OPTION PURCHASE METHODS
In Theory - The method of exercise should cost you the least possible out of pocket Minimize the "after-tax" opportunity cost Personal Assets/Cash - What is the present value of the after-tax return possible if invested in another asset? SECURITIES AND EXCHANGE RULES
Employees who are "Insiders" will be subject to the Short Swing rule of Section 16(b). Greater than 10% owner Director or Officer Employees who purchase stock must hold onto the stock for 6 months or all profits revert back to the company .SECURITIES AND EXCHANGE RULES - 1934
Exercise and Sell is not considered a 16(b) liability. As long as employee did not purchase company stock within 6 months of exercise and sale. If company stock is purchased within 6 months of option exercise - Exercise Strategies SEC Rules
Exercise and Hold
Personal Funds Matured Shares (Company shares owned > 6 months) Borrowed Funds Delay Exercise TAX ASPECTS
Tax Consequences of Non-Qualified Stock Options No Tax Liability at Grant Upon Exercise, the bargain element is Ordinary income to employee Company receives tax deduction on amount employee reports on form W-2. TAX ASPECTS
Withholding (Sections 3401 & 3402) 28% tax is required on:
Restricted Stock Severance Pay and gross up Non-Qualified Stock Options Withholding is not required on "Disqualified" Incentive Stock Options, however; Employer remains liable for any tax the employee does not pay, including FICA.TAX ASPECTS
Exercise of Incentive Stock Options triggers Alternative Minimum Tax (AMT) calculation. The difference between the Exercise Price and the Fair Market Value (Bargain Element) is a Tax Preference item for calculation of AMT. The Regular Tax (Form 1040) is compared to the AMT (Form 6251) The higher of the Regular tax or AMT Liability is paid. WHAT IS AMT?
Nearest thing to a "Flat Tax" Is designed to make everyone pay some tax Includes some items not taxable for regular tax, and disallows certain deductions Has an exemption that may be phased out WHAT IS AMT?
Current rates are Federal
26% for AMT income under $175,000 28% for AMT income over $175,000 You pay the higher of AMT or regular tax AMT ADJUSTMENTS
Income adjustments include: The "Bargain Element" on an ISO Exercise The impact of different depreciation schedules Adjustments to itemized deductions include: State & Local income taxes Property taxes Personal exemptions THE AMT EXEMPTION
May reduce your AMT taxable income If you are single and AMT income is less than $112,500, your exemption is $33,750 If you are married and AMT income is less than $150,000, your exemption is $45,000 If your income is higher than above, the exemption will be phased out THE AMT CREDIT
When in AMT you may generate a credit The credit is roughly equal to the difference between your AMT and regular tax. This is limited by the amount of AMT that is attributable to certain exclusion items. The credit can be used in future years to reduce your regular tax liability to your AMT, thus making the AMT a prepayment on future income taxes. (Rolling Preference Items) DISQUALIFYING DISPOSITIONS
Review: Holding period to qualify for long term gain treatment is at least 1 year from exercise and 2 years from grant. Any disposition of ISO shares before then is a "Disqualifying Disposition" If disposition happens in year of exercise, AMT is lessened. If disposition happens in a later year, there is no effect on AMT. DISPOSITIONS THAT DISQUALIFY (ISO’s)
Sale Gift Contribution to Charity Exchange Transfer of Legal Title Note that transfer to joint ownership is not a disposition. However, a change in joint owners is a disposition.
STOCK OPTION EXERCISE ALTERNATIVES
Alternative 1: Exercise and Sell Cash Out and Diversify Alternative 2: Exercise and Hold Own stock now, receive dividends, future appreciation taxed at lower capital gains rates Alternative 3: Delay Exercise No cash commitment now, anticipate growth. REVIEW
3 different alternatives at any one time A number of factors should influence your decision of when to exercise and when to sell. ISO’s require careful AMT and holding period planning but may have strong benefits. NQSO’s are generally more expensive to exercise. 83(b) ELECTION
Accelerates recognition of income to date option is exercised rather than when certain restrictions lapse. May be effective if the value of the shares is low and you expect the value to increase before your restrictions lapse. The election must be made within 30 days of exercise and must meet other filing requirements.
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