Presentation is loading. Please wait.

Presentation is loading. Please wait.

Approaches to Modeling Stock Options George K. Chamberlin, JD Vice President – Financial Strategies F I N A N C E W A R E ®

Similar presentations


Presentation on theme: "Approaches to Modeling Stock Options George K. Chamberlin, JD Vice President – Financial Strategies F I N A N C E W A R E ®"— Presentation transcript:

1 Approaches to Modeling Stock Options George K. Chamberlin, JD Vice President – Financial Strategies F I N A N C E W A R E ®

2 Approaches to Modeling Stock Options ® Building PAGE 2 Stock Options; Generally An important asset for many clients is stock options awarded by an employer. Stock options are a right in the recipient – employee – to purchase stock in the employer at a stated exercise price. Stock options may be either Incentive Stock Options (ISO) or Non-Qualified Stock Options (NQSO). The primary difference between the two categories lies in whether the options comply with the requirements of Title 26, U.S. Code, Section 422(b). If they comply, the options are qualified – ISO – and the exercise of the options is not considered to be a taxable event. Today, we will discuss stock options and considerations in modeling stock options in the context of your advice to clients.

3 Approaches to Modeling Stock Options ® Building PAGE 3 Requirements for Qualified Options - ISO Plan requirements » Options must be issued pursuant to a plan » Options must be issued only to employees » Employee may not be more than 10% owner of employer corporation Timing Issues » Option must be issued within ten years of creation of plan » Option must be exercised within ten years of issuance » Employee must not sell stock less than two years after issuance of option Pricing Issues » Value of options must not exceed $100,000 in a single year » Option exercise price must be equal to or greater than fair market value of stock at issuance of the stock option

4 Approaches to Modeling Stock Options ® Building PAGE 4 Taxation of ISO Where an option is qualified, » - The exercise of the option is not a taxable event » - The taxable event is the sale of the stock more than a year after option exercise » - The employee will be taxed on the gain, if any, on the sale of the stock » - The tax rate applicable to a qualified sale is the lower capital gains rate HOWEVER, beware the AMT trap » The difference between fair market value at exercise and the exercise price IS a tax preference item » The tax preference means that the employee must perform AMT calculation » If there is AMT liability, then the employee is taxed TODAY on gain that might NOT be realized on subsequent sale of the stock a year or more later.

5 Approaches to Modeling Stock Options ® Building PAGE 5 Another Approach to ISO Taxation Issues A qualified exercise requires cash to fund the exercise. It also may subject the employee to AMT if the preference item is significant or the employee has other preferences. An approach that addresses both of these issues is the option exercise and immediate sale of the stock acquired. » The options themselves supply the consideration for their exercise. » There are no AMT complications. » The employee is not in a concentrated position with employer stock. » Taxes are paid out of the proceeds of the exercise and sale. » The profits from the transaction may fund the next round of option exercise.

6 Approaches to Modeling Stock Options ® Building PAGE 6 What About NQSO? Any options that are do not qualify as ISO are NQSO. The exercise of NQSO results in immediate taxation on the excess of the fair market value of the stock acquired over the exercise price. This is taxation at the ordinary income tax rate – not the capital gains rate. As in the case of the exercise and immediate sale of an ISO, NQSO do not implicate AMT.

7 Approaches to Modeling Stock Options ® Building PAGE 7 What Should We Model? The first question is whether the options a client holds are ISO or NQSO. Most often, the options at issue are ISO and so we will focus on ISO in our modeling. Remember we always labor under the limitation that we do NOT know how the stock will perform over time. Thus, where the exercise price is MORE than the current market value of the stock – at the exercise date - then we will assume NO option exercise. No costs, no taxes but no gains (and nothing to model). And we may always exercise the options later. Where the exercise price is LESS than the current market value of the stock – at the exercise date – it is typical that the option be exercised unless there are other constraints. Next, we must determine – and analyze – the alternatives. The modeling alternatives are best addressed in a case study reflecting the possibilities.

8 Approaches to Modeling Stock Options ® Building PAGE 8 Case Study – Background The client is a mid-level executive employed by a corporation (the Company). The employer has decided that stock options are a way to encourage the client to remain with the Company and to maintain a high level of performance. The client’s anticipated retirement date is more than fifteen years away. To that end, pursuant to the current Company plan, the client is awarded 20,000 qualified incentive stock options with an exercise price of $20, which is the current market value of the Company shares. The client is entitled to exercise 2,000 options each year over a ten year period but may not, in any event, exercise any options before one year has passed from the issuance of the options. (Unexercised options are carried forward). This means $40,000 is needed for exercise each year. The Company has been performing well and it is anticipated that the stock price will rise with the planned release of an important new product and the proposed acquisition of another corporation. The client tells you that the price one year from now is expected to be over $35 per share.

9 Approaches to Modeling Stock Options ® Building PAGE 9 First Approach – Exercise and Hold Assumptions in the first scenario - » $40,000 cash to exercise is available » Stock current value at exercise is $35 » Client plans to hold the stock for at least one more year » We will examine ONLY the exercise of the first year’s options in this scenario » Our look at taxes applies only the federal taxes and not state income tax What happens next? » There is an AMT preference item of $30,000 so we need to calculate AMT » If AMT is due, we must model the additional present need of cash to pay » In our example we will assume $8,400 AMT paid (28% of $30,000) » Finally, we model the sale of stock one year later » If the fair market value remains flat – $35 – then the capital gain is $30,000 » At current long term capital gains rates, this means a tax of $4,500 » The $8,400 AMT credit (paid at exercise) will eliminate this tax – it may be used as a credit – and $3,900 is carried forward as an AMT credit.

10 Approaches to Modeling Stock Options ® Building PAGE 10 First Approach – Second Scenario The second scenario - » We will maintain the assumptions from the first scenario » $40,000 cash to exercise is available » Stock current value is $35 » Client plans to hold the stock for at least one more year » We are examining only the impact of one year’s options » Our look at taxes applies only the federal taxes and not state income tax » AMT was due on the transaction in year of exercise » Upon the sale of stock one year later » Assume the fair market value increased – to $40 – then the capital gain is $40,000 and the tax on long term gains at 15% is $6,000 » The $8,400 AMT credit (paid at exercise) will eliminate this tax – it may be used as a credit – and $2,400 is carried forward as an AMT credit for future years.

11 Approaches to Modeling Stock Options ® Building PAGE 11 First Approach – Third Scenario The third scenario - » We will maintain the assumptions from the first scenario » $40,000 cash to exercise is available » Stock current value is $35 » Client plans to hold the stock for at least one more year » We are examining only the impact of one year’s options » Our look at taxes applies only the federal taxes and not state income tax » AMT was due on the transaction in year of exercise » Upon the sale of stock one year later » Assume the fair market value decreased – to $30 – then the capital gain is $20,000 and the tax on long term gains at 15% is $3,000 » The $8,400 AMT credit (paid at exercise) will eliminate this tax – it may be used as a credit – and $5,400 is carried forward as an AMT credit for future years » The AMT $10,000 LOSS - $5 per share on which we paid AMT tax – creates a loss that can be set off against AMT gains » The usable loss is limited to current year AMT gains – any remaining loss may be carried forward for use in future years.

12 Approaches to Modeling Stock Options ® Building PAGE 12 First Approach – Comparing Scenarios Using the first approach, we have seen the three possible sales scenarios AND invoked the AMT. You can easily see the complexity introduced with the AMT. » What’s more is that the client can also see the complexity if AMT applies » Point out the continuing AMT issues with exercises in future years » Together with sales in subsequent years and the varying prices » Note that where AMT does NOT apply we again have three scenarios on sale » The sale scenarios mirror the sales prices outlined above » Except that there is no AMT tax paid nor AMT credit against the gains » These scenarios are simpler but may not be realistic given the growing applicability of AMT to taxpayers » Finally, each scenario or approach can be modeled across the ten years for the options granted – but the market value at exercise and sale is always uncertain

13 Approaches to Modeling Stock Options ® Building PAGE 13 Second Approach – Exercise and Immediate Sale Assumptions in this scenario - » $40,000 cash to exercise is NOT readily available » Stock current value at exercise is $35 » Client plans to fund exercise with a sale of the stock » We will examine ONLY the exercise of the first year’s options in this scenario » Our look at taxes applies only the federal taxes and not state income tax What happens next? » First, there is NO AMT preference and none of that complexity » Second, once we pay the $40,000 exercise price our proceeds are $30,000 » We are assuming no transaction expenses – just for simplicity » However, since we sell immediately, our gain of $30,000 is subject to ordinary income taxation » Assuming the client is in the 35% bracket, the tax due will be $10,500 » The client has, in hand, cash proceeds after tax of $19,500

14 Approaches to Modeling Stock Options ® Building PAGE 14 Second Approach – Different Impact Using the second approach, we have seen the relatively lower level of complexity involved. » Advantages of exercise and immediate sale include: » No AMT implications » Self-funding transaction » Lock-in gains at sale » Diversification and elimination of unwanted concentration in company stock » Disadvantages of this approach include: » Higher ordinary income tax rate on gains » Lost opportunity for future potential gains » May not comply with requirement to hold certain level of company stock

15 Approaches to Modeling Stock Options ® Building PAGE 15 Third Approach – Exercise and Partial Sale Assumptions in this scenario – same as for second approach » $40,000 cash to exercise is NOT readily available » Stock current value at exercise is $35, etc. What happens next? » First, we sell ONLY those shares required to fund the cost of exercise » The cost of exercise is not only the $40,000 exercise price but also the grossed up taxes on the transaction » We are assuming no transaction expenses – just for simplicity » Only that part of the gain that is recognized is subject to ordinary income taxation » Assume 1345 shares are sold at $35 to generate $40,000 exercise plus $7,061 ordinary income tax on the gain in those shares (with balance of $14 in cash) » The client will hold the remaining 655 shares The preference item relates only to the “gain” in the retained shares - $9825 – so AMT is not likely to be a problem

16 Approaches to Modeling Stock Options ® Building PAGE 16 Review of Approaches If we attempt to use a valid and thorough approach to modeling the impact of stock options on a client, there is no short cut or easy way to look at the issues. » The above approaches – or any one of them – could apply in each and every year of a particular grant of options » One could model ten straight years of gains – or of losses » One could alternate years with gain and loss » The possibilities – potential outcomes – are almost unlimited. » If a client has significant potential wealth in stock options » The first step is to evaluate the REST of the client’s finances and goals » The second step is to describe the approaches to exercise and sale » Then we may explain the volatility introduced by the stock options » Finally, we can gear our advice on levels – without the options and with them

17 Approaches to Modeling Stock Options ® Building PAGE 17 Corporate Valuation of Stock Options Quite apart from the approaches discussed above, the corporations issuing stock options also find themselves faced with the need to value stock options they have issued. » Corporations may elect to expense the stock options granted – writing them off – and this requires valuation of their potential future value. » Corporations may not expense the options but still need to be able to evaluate the impact of granting the options – dilution of share value or earnings often results from granting stock options to employees. » Among the methods of valuation used are the Black-Scholes pricing model and the binomial tree option pricing model – these methods are quite complex in their application. » We can learn from these approaches, too.

18 Approaches to Modeling Stock Options ® Building PAGE 18 We’ve looked at issues and approaches to modeling stock option issues. Are there any questions? Thank you, George Chamberlin (804) ext. 138


Download ppt "Approaches to Modeling Stock Options George K. Chamberlin, JD Vice President – Financial Strategies F I N A N C E W A R E ®"

Similar presentations


Ads by Google