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Where Do Restricted Stock & Stock Option Plans Fit in Your Financial Plan?

Stock Options
Once reserved for senior executives, the 1990s and early 2000s saw many large companies begin to award stock options at all levels of management and, in some cases, to rank and file employees.  The idea is to provide the employee an incentive to truly ‘take ownership’ in the company and its future profitability.  In recent years, firms have increasingly been granting shares of restricted stock alongside of, or instead of, stock options.
A grant of stock options gives the employee the right to purchase a fixed number of shares of the firm’s stock at a set price, usually the market price at the time the options are granted.  The options can be exercised after a prescribed vesting period.  Once vested, assuming the market price has gone up, the employee can exercise the options and either sell the shares for a profit or hold them in his or her portfolio.
Stock options come in two forms: Incentive stock options (‘ISOs’) and nonqualified stock options.  Nonqualified options are more common.  There is no tax to the employee when they are granted.  However, when nonqualified options are exercised, the difference between the market price of the stock and the option price (the profit, or “bargain element” as it is sometimes called) is taxable as ordinary income.  When the employee eventually sells the shares, any gain will be either short- or long-term capital gain, depending on how long the shares were owned.
Incentive stock options get special tax treatment.  Like nonqualified options, there is no tax when they are granted.  However, when exercised, there is also no tax1, as long as the shares are not sold (a) within 2 years of the date of the grant and (b) within 1 year of the date of exercise.  When the shares are eventually sold, as long as the two holding period rules have been observed, any gain on the sale will be treated as long-term capital gain, rather than ordinary income.
As welcome as a grant of stock options should be, it creates numerous financial planning questions.  Most revolve around when to exercise the options and how to fund the exercise.  When deciding when to exercise, considerations include:
  1. The expected growth in value of the shares
  2. The volatility of the stock’s performance
  3. When the options expire
  4. Whether the intention is to exercise and sell or exercise and hold
  5. Any applicable rules in company’s plan (e.g. a required holding period)
  6. Any requirement that options be exercised at retirement
  7. Current and future financial obligations
  8. Current and future tax situation
  9. The option holder’s risk tolerance
  10. How the stock fits in the overall asset allocation
Careful consideration of these ten factors should provide guidance on the optimal time to exercise.  Once the timing has been decided, there are generally four ways to fund the exercise of a stock option grant:
1.      “Cashless”: The options are exercised and the stock is sold simultaneously so that no cash is required from the holder.  A cashless exercise offers speed and immediate profit, but also results in less favorable tax treatment.  This can not be done with incentive stock options without disqualification.
2.      Stock Swap: If shares of the company are already held and the plan allows it, just enough of the shares are surrendered to cover the cost of the exercise.  This technique normally avoids capital gains tax on the surrendered shares.
3.      Loans:            It might make sense to borrow enough to cover the cost of the exercise if there is neither sufficient cash nor shares to cover the cost and a desire to avoid short-term capital gains tax from a cashless exercise.  The funds could be borrowed from a home equity line of credit or a margin loan secured by other securities held in a brokerage account.  Either of these could allow deductibility of the interest.  Both magnify the risk of the transaction, as it would be exceedingly painful to have to repay the loans if the value of the stock dropped in the subsequent period.
4.      Sell to Cover (ISOs only): At exercise, just enough of the shares are sold to cover the cost of the exercise.  The sold shares are taxed as ordinary income.          
Restricted Stock
A restricted stock grant does not require the employee to pay for the shares.  Instead, the grant comes with requirements designed to retain the employee for a certain period of time or to reward the achievement of certain business objectives.  When the restrictions have lapsed, the employee fully owns the shares and is taxed on the fair market value at that time at ordinary income tax rates. 
Holders of restricted stock grants do have the option of paying ordinary income tax on the market value of restricted shares, when granted, by making an election under section 83(b) of the Internal Revenue Code.  The holder can then delay taxation until the shares are eventually sold, rather than at the time they become vested.  Furthermore, they can enjoy long term capital gains treatment on any appreciation recognized upon their sale.

1 Although there are no ordinary income tax implications when an ISO is exercised and held, there may be alternative minimum tax.  Consult your tax professional.

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