ALAN S. MOORE

Popularity of company stock options increasing steadily

Not so long ago most employees in the United States went to work for one company and remained there until retirement. In exchange for job loyalty, these employees could count on the financial security of a company-paid pension plan to fund their golden years. Lifetime employment at the same company is no longer the norm. In fact, in many industries it is practically extinct. Today the job market is much more dynamic. Employees jump from job to job and have new compensation options including 401k plans, enhanced benefit plans, and more recently, stock option plans. Many recipients believe that being awarded stock options automatically translates into “money in the bank.” That is not always the case. Many of these recipients do not realize is that a stock option plan is actually a complicated financial agreement accompanied by complex rules. If you are currently participating in a company stock option plan, or considering taking advantage of a stock option opportunity, you should be aware that: you can exercise stock options and create taxable income without receiving any money-and still owe various taxes; and you could save thousands of dollars in taxes just by knowing the right tax strategy for your situation. What is a stock option? A stock option is a right to purchase a specified number of shares of stock at a determined price within a specified time period. An option agreement spells out how and when options can be exercised. Typically the exercise price is set at or near the value of the stock when the options are granted. The options are often exercisable in stages and usually expire after 10 years. Some companies will loan the money to exercise options or allow “cashless exercise.” With cashless exercise, the employee can borrow the money from a brokerage firm to exercise the options, and then sell the stock immediately, using part of the proceeds to repay the loan. What are the major types of Stock Options? There are two major types of Stock Options, Incentive Stock Options (ISOs) and Nonqualified Stock Options (NQSOs). The major difference between the two types of stock options relates to the tax consequences associated with their exercise. ISOs may qualify for favorable tax treatment for the holder of the options, while NQSOs generally will not. ISOs generally do not result in ordinary (compensation) income upon grant or exercise. Generally, if you meet the holding period requirements for ISO treatment, there is no regular federal income tax until you sell the stock acquired by exercising the options. At that time, the gains are treated as capital gains and are taxed at the favorable long-term capital gains rate. This is true only if the options are exercised and the acquired shares are sold in a manner that constitutes a qualifying disposition. Note that even with a qualifying disposition, there may have been some alternative minimum tax (AMT) consequences upon the exercise of the ISOs. In contrast to ISOs, Nonqualifying Stock Options have fewer rules and limitations. However, when you exercise a nonqualifying stock option you incur ordinary income equal to the difference between the value of the stock you receive and the exercise price of the option. If you are an employee, this income is subject to withholding. An employee receiving NQSOs generally may be taxed at any one of the following times: at the time you exercise the option; when you sell or dispose of the option; or when the restrictions (if any) on the disposition of the stock acquired by the option lapse. This is the case when the restrictions are such that there remains a substantial risk of forfeiture. As explained above, employees who receive ISOs are generally not taxed until they sell or dispose of the stock. Your Quick Reference Guide-ISOs VS. NQSOs Tax on Exercise Tax Basis Treatment of Sale of Acquired Stock ISO $0 (if qualified Disposition)* Note that an Alternate Minimum Tax will Apply Basis = Exercise Price Capital Gains from Date of Exercise*#~ NQSO Spread between fair market value on Exercise and Exercise Price = Ordinary income Basis = Market Value of Exercise Capital Gains from Date of Exercise*#~ * Stock held at least 2 years from date of grant and 1 year from date of exercise. *# If held for more than one year after exercise, the gain is subject to long-term capital gain. ~ Note that a disqualifying disposition changes the tax consequences Without the expertise to properly manage this investment, the likelihood of paying higher taxes and incurring them unnecessarily, is very high. Consult with an expert to develop a strategy for exercising your stock options that will help minimize your tax burden and assist you in meeting your financial objectives. Alan S. Moore is Financial Advisor of Legg Mason Wood Walker Inc., a diversified financial services and securities brokerage firm that is a member of the New York Stock Exchange and SIPC.