By Darrell J. Canby, CPA, CFP®

For many high-level employees, stock options have become too much of a good thing.
 
During the low-unemployment period of recent years, stock options have become a popular vehicle for recruiting and retaining quality employees. They provide an incentive for employees to perform to the best of their ability, while enabling them to share in their employer's success.
 
Many employees have amassed enormous wealth from stock options, but their long-term financial success may depend too heavily on the continued success of their employer. If a high percentage of their net worth is concentrated in their employer's securities, it is prudent for them to diversify. The question is how to accomplish that objective in the best financial manner. Several considerations should be evaluated when planning the exercise or sale of employer securities, including:
 
 • The risk the employee is willing to assume,
 • The risk to the business, and
 • Tax considerations (i.e., the amount the employee gets to keep after taxes).
 
The employee often owns stock outright and also has options to buy stock. Usually it is in the employee's best interest to keep any stock that is owned outright. These shares typically have a low tax basis and have been held long enough so that they will receive long-term capital gains treatment on their eventual sale. They also can be used in family gifting for estate planning purposes or education funding. So if the employee has a combination of stock and options, the challenge is to choose the best method for liquidating the options.
 
 Taxing Stock Options
 
When options are granted, there is no tax event unless a value can be placed on them. This is quite rare, so the tax event usually takes place when the options are exercised. The tax treatment varies based on whether the options are qualified or non-qualified:
 
Non-qualified options. When a non-qualified option is exercised, the "spread" is taxed as ordinary income, and will eventually be reported on the employee's Form W-2. The spread is the difference between the fair market value on the date the options are exercised and the cost of exercising the options.
 
The employer will withhold federal, state, FICA, and Medicare taxes on the spread. If the stock is not sold immediately, the employee will be required to pay the exercise cost and the withheld taxes to the employer. The employee may want to hold on to the stock to take advantage of long-term capital gains treatment, since the capital gains rate drops from 39.6% to 20% once securities are held for at least 12 months. However, the long-term capital gains treatment applies only to future appreciation of the stock and it may not be worth the risk. The employee would be paying cash to hold stock for a tax opportunity on appreciation that may not materialize.
 
Qualified options. When qualified options are exercised, the employee pays the exercise cost, but there is no income tax withholding requirement, even if the stock is sold immediately. In addition, as long as the stock is not sold, there is no taxable income for regular tax purposes.
 
However, the spread from qualified options is a tax "preference item" that needs to be considered in calculating the Alternative Minimum Tax (AMT). When calculating your AMT, adjustments are made to taxable income based on both preference items and exclusion items. Preference items result from timing differences, such as the spread on stock options that have been exercised, while exclusion items result from permanent differences. Once you calculate your AMT, it is compared to your regular tax, and you must pay the higher of the two.
 
While the AMT results in higher taxes, it also creates a tax credit. The AMT paid on exercised stock options is like a prepaid tax and a tax credit for the same amount is typically realized when the stock is sold.
 
Employees may want to exercise their options to start the clock ticking so they will be eligible for the 20% long-term capital gains rate on the spread, but, as a result, they may end up paying the AMT at a rate of 28%. If the employee exercises options and sells the resulting stock simultaneously, the tax rate could be as high as 40% for federal tax purposes. In some cases, the employee can reduce the AMT by exercising and selling some shares immediately, and holding the remaining shares for long-term capital gains treatment.
 
 Minimizing Taxes
 
Several factors must be considered to determine the approach for selling and exercising stock options that will result in the lowest taxes overall.
 
Many tax practitioners calculate taxes based on various scenarios over a two-year period. The examples show the cost in both year one (the exercise year) and year two (the selling year). The incremental tax cost over both years can then be analyzed to determine the lower amount. These analyses are important, but may not provide all of the necessary data.
 
An alternative method is to review the entire stock and stock option portfolio on a net-worth basis. To arrive at the after-tax net worth of the stock that is or will be acquired, the first step is to compute the value of the stock and stock options, reducing the value for the deferred-tax cost. The deferred-tax cost of stock held more than one year is at the long-term capital gains rate of 20%. The deferred-tax cost of non-qualified options is computed at ordinary income tax rates, which may be as high as 40%. Finally, the deferred-tax cost of option shares that have been exercised may be 20%, 28% (the AMT rate) or up to 40%.
 
Any AMT tax credit should also be considered. As mentioned earlier, if you paid AMT because you included the spread in your calculation, the tax paid creates a credit. The tax credit carryover is often an essential element in determining the ultimate taxation strategy.
 
It is difficult to generalize, since individual situations can be dramatically different, but we typically advise clients to immediately sell stock that is acquired under a non-qualified arrangement. The spread is taxable immediately and withholding is required. It may be best to liquidate the stock to provide the employee with cash to pay the tax. In addition, the employee can use the proceeds to diversify his or her portfolio.
 
In addition, it is often worthwhile to sell shares from exercised qualified options in the same year that you exercise non-qualified options, because the resulting high ordinary income will reduce AMT implications. If you still have AMT exposure, you may want to simultaneously sell some of the options to have cash to pay the tax (at the AMT rate of 28% versus the normal 40%), and perhaps to diversify your portfolio. Using this strategy, you may also realize any AMT credit sooner than you would using a holding strategy.
 
Lastly, a strategy of quarterly liquidation may make sense to avoid the perception of trying to time the market, especially if you are an officer. The amount of shares to sell can vary depending upon your short-term view of the price.
 
These issues involve a very complex area of the tax law. We recommend that you consult with your advisors before implementing any of the techniques discussed above. Each individual's goals, objectives, and investment history are different, so specific advice should be tailored to each situation.

Darrell Canby is one of the founding partners of Canby Maloney & Company in Framingham, Mass. He currently is President of Canby Financial Advisors, LLC, a registered investment advisor. Mr. Canby is a CPA and CFP^®, and is licensed to sell securities.