As the technology bubble burst, many employees who exercised stock options learned a painful lesson: Although this popular form of compensation has generated significant wealth, options also have threatened their owners' financial security. By not anticipating the tax consequences and risks of certain stock option strategies, a potentially valuable asset can create liabilities.

Insolvency is less likely to result from exercising nonqualified stock options than exercising incentive stock-options. This is because employees must pay tax on NQOs up-front through withholding. However, those who exercise NQOs and dare to hold the stock--anticipating future value increases and long-term, capital gain tax benefits--do expose themselves to risk.

In fact, the potential downside of an exercise-and-hold strategy for NQOs is greater than ISOs, since the former is subject to a higher tax prepayment risk.

Two Different Beasts
NQOs differ from ISOs in several important ways:

• NQOs, unlike ISOs, may be in-the-money when granted (i.e., the stock FMV is in excess of exercise price).
• The gain for NQOs is taxed as compensation on exercise. By contrast, for regular tax purposes, an ISO gain is taxed when the stock is sold.
• NQO gain, unlike ISO gain, is not eligible for long-term capital gain treatment, except for stock appreciation after it is exercised. Accordingly, NQO gain on exercise is subject to tax at the highest marginal rate.
• For NQOs, AMT treatment mirrors regular tax treatment so AMT is not an inherent planning consideration. For ISOs, the spread at exercise is subject to AMT, so AMT is a major issue.
• Since NQOs are not tax-favored, they tend to have more flexible terms than their ISO counterparts.

Despite the differences, advising clients with NQOs presents a similar dilemma as ISOs: What to recommend without knowing the future stock price. An effective approach is to advise your clients on the risks and rewards of potential NQO strategies, while keeping in mind that different strategies apply to those who work for mature companies versus startups.

NQOs and the Mature Company
"Tom" works for a large, established Silicon Valley software company and wants to reduce the taxes on his NQOs. Four years ago, Tom was granted 62,000 NQOs exercisable at $7 per share, when the stock was selling for $10 per share. A year ago the stock was worth $70 and now it is worth $50. The NQOs were granted with a built-in bargain element on the grant date. Typically, the NQOs lack a readily ascertainable FMV (as narrowly defined in Sec. 83) and as a result are not taxable on the grant date.

Tom believes his company's stock will rebound to its previous price and wishes to take advantage of long-term capital gain rates on the appreciation. He would like to base his strategy on an assumption of the stock rising to $70. Tom has a choice of three strategies:

• Exercise and sell (same-day sale);
• Delay exercise; or
• Exercise and hold.

Tom's potential capital gain benefit is limited to the post-exercise stock appreciation. Compensation income of $43 per share would be recognized upon exercise and the cost basis will be equal to the FMV as of the exercise date ($50). Tom should be made aware not only of the tax savings benefits of his contemplated strategy, but also the risks.

Weighing the Potential Outcomes
The graph on this page illustrates the potential outcome and risks of the three strategies depending on the timing and stock price upon sale. The analysis incorporates the net value realized after the second year which is derived from the proceeds from the stock's sale, total taxes paid and, in the case of a buy-and-hold strategy, the cost of financing to fund the exercise price and tax withholding. For a same-day sale in the first year, it includes investment return, if proceeds were invested.

The following assumptions have been made:

• 62,000 options at the $7 exercise price;
• Ordinary income from exercise taxed at 46 percent (top marginal rates plus Medicare);
• Capital gains are taxed at 29.3 percent (no deduction for state taxes due to AMT);
• Financing cost--6 percent to finance withholding, exercise cost to buy and hold; and
• Rate of return on proceeds invested--6 percent (after tax).

If the stock appreciates 40 percent while holding, the employee accumulates approximately $140,000 more from tax savings. With a 40-percent decline, the total amount realized with an exercise-and-hold strategy is less than $100,000 compared to a delayed exercise and same-day sale at that same price yielding almost $800,000.

This punitive outcome results from paying tax on what was ultimately unrealized or "virtual" gain on the stock's value at exercise plus the cost to finance the exercise cost and tax withholding. A capital loss results and without capital gains to absorb the loss, there will be a large and currently unused capital loss carryover. In our example, the loss carryover is about $1.2 million. This risk-reward proposition makes it very difficult to justify an exercise-and-hold strategy.

The exercise-and-hold strategy may be more expensive with NQOs than ISOs if the stock price declines. And if the stock drops after exercise, with an NQO there is no opportunity to "undo the damage" before the end of the calendar year using a disqualifying disposition and limiting the income to the sales price.

The tax rate on the exercise of an NQO is typically much higher (i.e., federal rates of 38.6-percent ordinary rate vs. 28-percent AMT rate for an ISO, and California 9.3-percent ordinary vs. 7-percent AMT). Also, the financing cost is higher for an NQO at exercise since most of the taxes must be paid immediately through withholding.

With a mature company, our most effective role as advisers is to educate the client to avoid what might appear to be a tax-minimization strategy of exercising and holding, and focus instead on a wealth-preservation strategy by either executing a same-day sale or delaying exercise until a sale is contemplated.

The same-day sale approach avoids tax prepayment risk. Although the exercise-and-hold approach may result in a relatively small tax savings, advisers should communicate how the risk overshadows the reward by demonstrating these types of scenarios.

Substantial Risk of Forfeiture
If stock acquired on an NQO exercise is nontransferable and subject to substantial risk of forfeiture, then Sec. 83(a) applies to the stock rather than the option. This means that the gain is deferred until the restrictions lapse.

Assume Tom exercises the options this year when the stock is worth $50, but the stock is restricted until he fully vests by completing another year of employment. He must return the stock to the company if he quits early. Tom expects the stock to be worth $70 at the end of his vesting year.

How does this change our analysis? Sec. 83(a) delays ordinary income recognition until the stock vests and the entire spread of $63 ($70 minus $7) per share is ordinary income on the vesting date. The same result would arise if the stock were not expressly forfeitable, but Tom was subject to insider trading restrictions imposed by Sec. 16(b) of the 1934 Securities Exchange Act.

Alternatively, Tom could make a Sec. 83(b) election to recognize the spread on exercise as ordinary income immediately. Tom would have compensation income of $43 per share in the current year and the balance would be capital gain when the stock is sold.

Risks increase with the Sec. 83(b) election. If Tom made the election, recognized $43 ($50 minus $7) per share of compensation income on exercise and subsequently forfeited the restricted stock (with the company giving him back his exercise price of $7), then his deductible loss on forfeiture would be zero, despite the $43 of income previously recognized. [See Code Sec. 83 (b)(1) and Reg. Sec. 1.83-2(a)]. The Sec. 83(b) election is exceptionally risky when the spread at exercise is large, particularly if forfeiture is likely.

NQO and the Startup
Prior to establishing a going-concern business, stock value is quite low. A cash-poor startup may rely heavily on stock options to compensate its employees, and the delayed vesting of the stock provides incentive for employees to stick with the new company.

Unlike Tom for whom the Sec. 83(b) election was extremely risky, with a startup, failure to make the election may result in a lost opportunity to reduce taxes significantly if the company is successful. The spread at exercise is often insignificant with the possibility of phenomenal post-exercise stock appreciation.

"Jane" joined a biotechnology startup that plans to have an IPO pending FDA approvals. She was granted 100,000 NQOs for which the underlying stock will vest annually over the next four years. Jane's options can be exercised prior to the stock vesting, subject to a buy-back by the company at the exercise price if she quits early. Jane must remain employed by the company for the stock to vest. The option's exercise price and the stock's current FMV is $1 per share.

Because Jane can exercise the options before the stock vests, her available strategies are:

• Exercise and hold; or
• Delay exercise until vesting and hold or sell at that time.

Jane has an incentive to exercise the NQOs before the stock value rises and make a Sec. 83(b) election for all of the restricted stock received. This will ensure capital gain treatment on subsequent appreciation, but she must exercise the NQOs (and receive the restricted stock) before she can make the 83(b) election.

Delaying exercise, delays the need to pay out the exercise price; however, the stock value may increase in the interim. As the stock price climbs and the spread widens before the NQOs are exercised, the Sec. 83(b) election becomes less desirable. If the stock is vested when the NQO is exercised, then the spread is ordinary compensation income without the alternative of a Sec. 83(b) election.

If all of Jane's options are exercised when the stock value equals the exercise price of $1, then the stock's cost basis will be $1 per share and with the Sec. 83(b) election, any subsequent appreciation will be treated as capital gain.

Assume the IPO is successful and the stock soars to $50 per share. Jane's gain of $4.9 million, taxed as long-term capital gain, yields a tax savings of approximately $800,000 (assuming the combined effective rate on ordinary income including Medicare tax is 46 percent vs. 29.3 percent on capital gains).

Alternatively, if we assume that the stock becomes worthless, then two possibilities emerge:

• Jane forfeits the stock before it vests and gets her exercise price back from the company (zero gain or loss); or
• The company goes out of business or the stock tanks before Jane can sell and she loses her $100,000 investment--capital loss of $1 per share.

Although the potential rewards are great, the employee must be willing and able to risk the full amount of the exercise price. Over the years, most startups have failed and recently this has been the destiny of many high-tech startup companies. In fact, estimates on Internet startup failures range from 50 percent to 95 percent.

Different NQO strategies carry varying levels of risk. The strategy with the least risk, although potentially highest tax, is a same-day sale. An exercise-and-hold strategy carries investment risk (what is paid to exercise the option), along with a tax-prepayment risk. The most problematic case for an exercise-and-hold strategy involves a company, often a mature one, where the spread on exercise is large. Here, the tax law adds significant prepayment risk that dampens the upside and capital loss limits that magnify the downside.

Karen Goodfriend, CPA/PFS, is a partner in the Menlo Park office of Goldstein Enright Financial Advisers and is a past chair of CalCPA's Personal Financial Planning Committee. She can be reached at kgoodfriend@goldstein-enright.com.

Gary R. McBride, JD, LLM, CPA, is a professor in the graduate tax program at CSU Hayward and a consultant to Froshman, Billings & Williams. He can be reached at garymcb@att.net.

© 2002 California Society of Certified Public Accountants. For reprint permission, contact Aldo Maragoni, managing editor.