Stock Option Planning

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Stock Option Planning

• Texas AM University
• Accounting 405
• February 17, 2000

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An alternative tax return....(From the
Washington Times)Dear IRS"Enclosed is my 1999
tax return payment. Please take note of the
attached newspaper article and you will see that
the Pentagon is paying 171.50 for hammers and
NASA has paid 600 for a toilet seat. Please
find enclosed four toilet seats (value 2400) and
six hammers (value 1029). This brings my total
payment to 3429. Please note the overpayment of
22 and apply it to the Presidential Election
Fund, as noted on my return. Might I suggest you
send the above mentioned fund a 1.5 inch screw.
(See attached article HUD paid 22 for a 1.5
inch phillips head screw.) It has been a pleasure
to pay my tax bill this year, and I look forward
to paying it again next year.
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Agenda

• Introduction
• Definitions
• Non-Qualified Stock Options (NQSOs)
• Incentive Stock Options (ISOs)
• Real-Life Exercise and Planning Considerations

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Introduction - Stock Options

• Right to buy company stock at a fixed price at a
  future date.
• Pay for Performance - method of compensation
• Two types of Stock Options
• Non-Qualified Stock Options (NQSOs)
• Incentive Stock Options (ISOs)

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Introduction - Stock Options

• Compensating Employees
• Creates a common interest between shareholders
  and executives
• Long-term potential for significant wealth
  accumulation
• Promotes team approach
• Tax advantages

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Definitions

• Grant Date - The date options are awarded to an
  employee
• Vesting - Period of time that must elapse
  before the options can be exercised

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Definitions

• Exercise Date - The date on which the exercise
  price is paid and stock is received
• Spread - Excess of the fair market value of the
  stock over the exercise price at the date of the
  exercise
• Expiration Period - Options become worthless
  depending on the terms of the plan
• Most plans have a 10 year expiration period

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Non - Qualified Stock Options (NQSOs) - Tax
Treatment

• Date of Grant
• No tax consequences at grant

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NQSOs - Tax Treatment

• Date of Exercise
• Excess of the fair market value of stock over the
  exercise price (Spread) is taxed as ordinary
  income
• Withholding taxes are due on or about the
  exercise date
• Company receives a tax deduction!!

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NQSOs - Tax Treatment

• Sale of Stock After Exercise
• General Rule Stock cost basis after exercise is
  the FMV at exercise date
• Generates capital gain or loss if held gt 12
  months
• Short-term (ordinary) rates if held lt 12 months.

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Incentive Stock Options (ISOs)

• Favorable Tax Treatment
• With proper planning, all appreciation above an
  ISOs exercise price is taxed at long-term
  capital gains rates

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ISOs - Tax Treatment

• Date of Grant
• No tax consequences at grant

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ISOs - Tax Treatment

• Date of Exercise
• At the time of exercise, no regular income tax
  consequences
• The spread at exercise is an AMT adjustment item
  (Becomes AMT taxable income)
• No tax deduction for company!!

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Alternative Minimum Tax (AMT)Everyone Must Pay a
Minimum Amount of Tax
Taxable income before exemptions for regular
tax AMT Adjustments Exemption (45,000 - MFJ
33,750-S) Alternative minimum taxable
income 26 (up to 175,000) 28 (over
175,000) Tentative Minimum Tax (TMT)
START WITH PLUS/MINUS LESS EQUALS TIMES
EQUALS
IF TMT gt REGULAR TAX, YOU PAY THE GREATER AMOUNT
. . . And ask your tax return preparer about the
minimum tax credit for the next year
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ISOs - Tax Treatment

• Cost Basis
• Regular Tax Purposes
• The basis of the stock received is equal to the
  exercise price paid in cash
• AMT Purposes
• Fair market value on the date of exercise
• AMT basis is higher than the basis for regular
  tax purposes

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ISOs - Tax Treatment
Capital gain for AMT
Capital Gain for Regular Tax
FMV on Exercise Date
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Preference for AMT
Cost Basis for AMT
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Option Price
Cost Basis for Regular Tax
Sale Date
Exercise Date
Tax rate will depend upon how long stock is held
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ISOs - Tax Treatment

• Sale of ISO Acquired Shares
• Must meet holding period requirements to maintain
  favorable ISO status
• Two years from Date of Grant, and
• One year from Date of Exercise
• The difference between the gain or loss reported
  for Regular Tax and that figured for the AMT is
  entered on Line 9 of Form 6251. If AMT gain is
  less than the Regular Tax gain, enter difference
  as a negative.

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ISOs - Tax Treatment

• Subsequent Increase in value From Exercise Price
  is Long-Term Capital Gain
• Must be held at least 12 months
• Subject to investment risk

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Case Study Example

• November 13, 1998 - granted 1,000 ISOs
• Exercise price - ?
• 500 options vest after 1 year, 500 options vest
  after 2 years
• FMV _at_ December 31, 1999 30
• FMV _at_ January 2001 100

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Case Study Example

• November 13, 1998 - granted 1,000 ISOs
• Exercise price - 20
• 500 options vest after 1 year, 500 options vest
  after 2 years
• FMV _at_ December 31, 1999 30
• FMV _at_ January 2001 100

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Disqualifying Disposition

• Triggered if Holding Period Requirements are not
  met on ISOs. (i.e., Stock is Disposed Of
  Within
• Two Years of Option Grant or
• One Year After Exercise)

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Disqualifying Disposition

• Loss of favorable Capital gain treatment
• Appreciation above market price is short-term
  capital gain
• NQSO tax treatment

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Disqualifying Disposition

• NQSO Tax Treatment - However. . .
• Not subject to federal income tax withholding
• No Social Security / Medicare taxes
• Company Now Gets a Corporate Income Tax
  Deduction!!

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Disqualifying Disposition

• Tax consequences if disposition occurs in year of
  exercise.
• No AMT Consequences
• NQSO Tax Treatment

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Disqualifying Disposition

• Tax Consequences If Disposition Occurs in Year
  After Exercise
• Client receives a Credit for prior year
  increase to Alternative Minimum Taxable income
  that resulted in AMT paid
• Basis for AMT purposes now equals basis for
  regular tax purposes

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Case Study Example

• November 13, 1998 - granted 1,000 ISOs
• Exercise price 20
• Exercise 500 shares January 2001
• FMV _at_ January 2001 100
• Marginal tax rate 39.6

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Exercise Considerations

• Company requirements for stock ownership
• Age of the options
• Anticipated growth in stock value
• General market conditions
• Employees cash flow and financial planning needs
• Employees overall investment objectives

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Exercise Considerations (cont.)

• Employees may not be able to sell at all times
  due to lock-up periods or black-out windows
• How will the employee pay for the option?
• Cash or shares of stock

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Planning Considerations

• Are the options transferable?
• Must consider tax aspects of exercise as well as
  diversification issues

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Planning Considerations (cont.)

• Must consider after-tax proceeds
• For example, if an employee believes that the
  stock price will fall substantially over a period
  of time, he/she has two options
• a disqualifying disposition of 100,000 at a
  39.6 tax rate, or
• meeting the holding period requirements of ISOs
  to generate proceeds of 50,000 at a 20
  long-term capital gains rate.
• Which would you rather have?????

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Planning Considerations (cont.)

• If employee has both NQSOs and ISOs, he/she may
  be able to exercise additional ISOs in a given
  year without incurring AMT simply by exercising
  some NQSOs.
• Can you explain what would cause this to happen?

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Planning Considerations (cont.)

• Answer Exercise of NQSOs increases ordinary
  income and allows additional AMT preference
  without any additional tax.
• At what rate is withholding taken out on NQSO
  exercises?

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Planning Considerations (cont.)

• Underpayment Penalty - (for lack of withholding)
• Interest based penalty
• Two Safe Harbor tests the employee can meet
• If neither Safe Harbor is met, estimated tax
  payments are required
• Estimated tax payments are due on April 15, June
  15, September 15 and January 15 of the next
  calendar year.

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Conclusion

• Our Role as Financial Planners/Tax Advisors
• Develop a systematic exercise program
• Keep track of stock basis
• Propose alternative uses of shares
• Watch income tax ramifications
• AMT
• 2210 (Underpayment) Penalty

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