NQSO strategies - avoiding past mistakes.

• Author: Goodfriend, Karen
• Position: Nonqualified stock options

With a prolonged bear market And a slide in technology stock prices, employee stock options have lost much of their luster. When the technology bubble burst, many employees who had exercised options learned a painful lesson. Although this popular form of compensation generated significant wealth for many, it also threatened others' financial security. By not anticipating the tax consequences and risks of various strategies, this potentially valuable asset became a liability. This article focuses on the tax treatment of nonqualified stock options (NQSOs) and some NQSO strategies that can avoid unsavory tax consequences. (For a discussion of incentive stock options (ISOs), see Dennedy, Personal Financial Planning, "ISO Portfolio Planning Issues," TTA, July 2002, p. 459.)

Past Blunders

Many stock option holders who took risks in the 1990s did not consult tax advisers and were unaware of some tax and economic consequences of their actions. As taxpayers were filing their 2000 returns, dramatic stories of insolvent taxpayers owing alternative minimum tax (AMT) as a result of exercising their ISOs unfolded in the media.

Example 1: In early 2000, M exercised 10,000 ISOs for $20 per share when her employer's stock peaked at $100 per share. By year-end, the technology stock was worth $5 per share; M continued to hold the stock. In April 2001, she discovered that in addition to being out-of-pocket $20 per share for the exercise price, she owed AMT tm the $800,000 spread on exercise (($100 stock fair market value (FMV)--$20 ISO exercise price) x 10,000).When M finally sold the stock in May 2001 for $1 per share, she recovered only $10,000 and owed more than $200,000 in AMT.

Had M sold the stock when she exercised the option, she would have made a huge profit. Unfortunately, a same-day sale probably had little appeal to M at the time. M undoubtedly believed the stock price would rebound, and focused instead on the primary tax advantage of ISOs--long-term capital gain treatment. M held the stock for one year, without considering whether the price would decline or whether she would owe AMT. There was no withholding on exercise and M, like so many others, had no funds set aside to cover the liability.

Dissimilar Vehicles

While most of these tales of woe involved ISOs, NQSOs pose similar risks. Employees who exercise NQSOs and dare to hold the stock in anticipation of value increases and long-term capital gain tax benefits, expose themselves to a risk greater than that of ISOs. NQSOs are potentially subject to a higher tax prepayment risk, because their spread at exercise is taxable at ordinary rates (usually higher than AMT rates).

Many taxpayers are unaware of this and become tempted by today's lower capital gain rates. The lessons of the 1990s were so dramatic that taxpayers cannot always appreciate that even a less volatile stock market poses risks to strategies that maximize capital gains.

NQSOs differ from ISOs in several important ways:

* For NQSOs, there is withholding on exercise.

* Unlike ISOs, NQSOs may be in-the-money when granted (i.e., the stock's FMV exceeds the exercise price).

* NQSO gain is taxable as compensation on exercise. By contrast, for regular tax purposes, ISO gain is taxable when the taxpayer sells the stock.

* Unlike ISO gain, NQSO gain is not eligible for long-term capital gain treatment, except for stock appreciation after exercise. Accordingly, NQSO gain on exercise is taxable at the highest marginal late.

* For NQSOs, AMT treatment mirrors regular tax treatment, so AMT is not an inherent planning consideration. For ISOs, however, the spread at exercise is subject to AMT, a major consideration.

* Because NQSOs are not tax-favorable, the, they tend to have...