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Financial Planning > Tax Planning

Know Your Options

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While things have been pretty quiet since the tech boom of the 1990s, stock options are in the news again. Today, ongoing investigations related to companies backdating their employer-awarded stock options have once again brought new media attention on this method of equity compensation, and memories — both positive and negative — linger. On the positive side, advisors and clients alike can recount stories of young Silicon Valley stock-option-millionaires. On the negative side, some might cringe at the memory of incurring Alternative Minimum Tax (AMT) liabilities from exercising ISO options during market declines.

Employer awards of both stock and options continue to be important components of the way managerial and executive-rank employees are compensated. Studies show that these instruments are still popular in all types of business, with a full 15 percent of publicly traded companies offering some form of stock options to most or all employees.

As a result, advisors should be prepared for a resurgence of questions about options from current and potential clients alike. Even if dealing with these concentrated positions never becomes a large part of your overall practice, clients will still need your help to understand how to make the most of these additional assets as part of their overall portfolio.

Tax, Investment and Cash Flow Issues

Potential tax consequences related to exercising employer stock options include: regular income tax, AMT, payroll and FICA taxes, short-term capital gains and long-term capital gains. Different tax results could be obtained from the same stock grant award depending on whether the client exercises Incentive Stock Options (ISO) or Non-Qualified Stock Options (NQSO), when they exercise the options and how long they hold the stock. Whether you have the expertise to educate your clients personally or simply refer them to a tax specialist, conducting an advance discussion of various stock option strategies and their implications can shield them from unpleasant tax surprises.

Stock options also present several investment and cash flow questions. For example, if clients are already receiving employer incentives such as restricted stock units or matching in their 401(k) plans in the form of stock, how much additional risk should they take on by holding employer stock outright? In addition, irregular and/or periodic shortfalls in living expenses can beg the question whether stock option proceeds, payroll income or portfolio assets best satisfy these cash flow needs.

Finally, as a trusted advisor, you should strive to discuss with each of your clients the coordination of employer stock held outright, employer stock held within retirement plans and shares available through employer stock grant awards. Because of the inherent leverage stock options provide, they should be the last asset to diversify out of in the majority of circumstances; however, most investors mistakenly assume stock options should be the first assets to exercise. Especially in these circumstances, advisors have the ability to bring incremental value — both financial and educational — to the client relationship. By serving as a knowledgeable guide equipped to discuss the potential rewards and pitfalls of the client’s stock option situation, you can create a strong competitive advantage compared to other advisors.

Triggers for Option Activity

As with all other client assets, stock options should be evaluated on how they may be utilized to achieve the client’s overall financial goals. There is just one problem here. Until the client actually initiates the options, they will not create real or nominal wealth. On the other hand, if reducing risk in an employer’s stock is a client priority, the decision of whether to exercise or hold options may not be as clear.

Savvy advisors can help their clients discuss potential stock option activity by setting triggers for action in advance. One trigger may be the passage of time. For example, the client and advisor could agree that they will evaluate the client’s stock option portfolio two months before the annual grant award. This facilitates regular and consistent review of the client’s stock option portfolio and ensures options will not expire with value.

Another trigger may be when the company stock attains a predetermined price. For example, if both client and advisor determine that an 8 percent pre-tax rate of return is needed to achieve the client’s investment goals, action could be prompted if the stock price for the options hits or exceeds the target rate of return.

Ideally, specific and quantifiable triggers for action would be agreed upon in advance. For example, clients may agree to exercise one-third of profitable options every January or exercise options once they have appreciated 50 percent above their strike price. At the bare minimum, clients should commit to authentic discussions about potential stock option activity once triggers are achieved.

Time Periods for Client Discussions

Typically, stock option grants are awarded to employees in the same month each year. Since companies will choose this month based on their own fiscal parameters, the first thing you will want to do is to determine when the client can expect the annual grant award. For example, you may have a client whose stock option grant statement may list successive grants awarded in the month of April. With this information in mind, consider the following times to discuss stock option issues with your clients:

Before Grant Month Before the grant month, (1) request upcoming grant information, (2) review expiring grant awards (if applicable) and (3) review client financial goals, especially if they are to be paid out of stock option proceeds.

After Grant Month After the grant month, meet with clients to review (and exercise) strategies for their stock option portfolio, including how it coordinates with their overall investment, tax and income situation for the year.

Last Quarter of Calendar Year Prior to the end of the year, assist clients with the tax and investment implications of stock option activity for the entire year. For example, discuss such items as the client’s potential AMT liability from an ISO exercise — or a payroll tax withholding from an NQSO exercise.

The last quarter of the calendar year is also the time to determine whether stock option activity should be initiated prior to year end. You could, for example, determine if stock option expiries in the following year will produce large amounts of taxable income and as such should be exercised in such a way that the income is split into two tax years instead of one. Or if the stock has lost value over the year, evaluate whether to initiate a disqualifying disposition of ISO exercise in order to eliminate AMT liabilities.

Advisor Help Is Needed

According to a 2005 Bureau of Labor Statistics survey, approximately 10 million people (or 8 percent of all private sector employees) have stock options. This broad base of the American population — both current and potential clients — needs professional help to maximize the additional wealth these assets can provide. As this type of compensation continues, will you be ready?


Marie Swift is president of Impact Communications ( and Trudy Turner is with Robertson, Griege & Thoele, a Dallas-based independent wealth management and RIA firm.


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