Stock Options and 20/20 Hindsight
Exercising Options with a CRT Strategy
Jeri Beckett (47), a software engineer, specializes in writing manuals
and promotional materials for a rapidly growing technology firm.
She's divorced and has three children (the youngest completes her degree
in May), and Jeri has been offered an option package as a "golden handcuff"
to keep her from being recruited by a competing company. She's heard
the horror stories about employees who accept options as compensation only
to have their options be underwater (subtract the price paid to exercise
the option from the current fair market value; if the FMV is less than
the option price, it's "under water") or wind up owning pieces of companies
that go out of business. What to do?
A common employee problem is that all of their assets are tied to one
employer, e.g., they own company stock and options to buy more, their pension
plans own employer stock, even the real estate market is affected by the
stability and profitability of their employer. Out of a misguided
sense of loyalty, their portfolio is completely undiversified and adversely
affected when the market gyrates. While some employees have made
great wealth by riding the market roller coaster up, many have found themselves
paid with paper that turns out to be worthless.
How to address these concerns? Many advisors suggest diversification,
and one way to accomplish that is to have a coordinated strategy that meets
the needs for both financial and estate planning. One solution
for Jeri is to exercise her options on a regular basis, hold the shares
for a year and then contribute some of those shares to her charitable remainder
trust (CRUT). The reason for this strategy?
-
Since she has both qualified or incentive stock options (ISO) and
nonqualified stock options, she needs to address the income tax problems
of exercising those options as well as have the cash needed to buy the
stock. While the exercise of an ISO may generate an alternate minimum
tax (AMT) based on the difference between the FMV and exercise price, the
nonqualified stock option will generate ordinary income tax liabilities
on the bargain sale component.
-
Options are granted with an expiration date, by exercising them regularly
she can keep up with the need for cash to redeem them and buy the stock
without borrowing.
-
By buying the stock and holding it for a year before selling (there
may also be a two year holding period from grant date), the stock qualifies
for more favorable capital gains, instead of higher ordinary income tax,
treatment when stock is immediately sold.
-
The CRUT allows Jeri to make an annual decision to contribute between
30% and 100% of her stock to her tax exempt trust and sell the contributed
stock without a current capital gains tax liability as she diversifies
her portfolio. Every year the CRT accepts her stock, it generates
an income tax deduction that helps offset either the tax from exercising
her options or any tax created when she keeps some of the stock for her
personal account. Besides the tax deduction, the CRT will distribute
income annually to help finance her ongoing stock purchases. For
this plan to work properly Jeri needs to start immediately and be consistent,
otherwise the significant amount of money and time needed to make the plan
work will overwhelm her. This "reverse dollar cost averaging" strategy helps Jeri avoid being caught
if her company's stock tumbles and avoid some of the "what if" questions
that plague investors when they look at what might have been if they'd
locked in the value of their high flying stock before it dropped in value.
| Beckett Family Stock Option Choices |
Incentive Stock Options (ISO) |
Non Qualified Stock Options (NQSO) |
Traditional (Non CRT)
Sale of NQSO |
| Option Price for One Share |
$1.00 |
$1.00 |
$1.00 |
| FMV of One Share at Exercise Date |
$5.00 |
$5.00 |
$5.00 |
| Gain in One Share |
$4.00 |
$4.00 |
$4.00 |
| Tax on Gain (highest ordinary federal rate of 39.6%) |
May have AMT, otherwise $0 |
$1.584 |
$1.584 |
| Basis of One Share after Exercise of Option |
$1.00 |
$5.00 |
$5.00 |
| FMV after Holding in Investment Portfolio (3 years) |
$10.00 |
$10.00 |
$10.00 |
| Capital Gain if Stock is Sold |
$9.00 |
$5.00 |
$5.00 |
| Tax on Realized Gain (only if sold, federal capital gains rate
of 20%) |
$1.80 |
$1.00 |
$1.00 |
| Taxable Investment Account Value (non CRT) with 10,000 Shares of Optioned
Employer's Stock |
-- |
-- |
$100,000 |
| Initial FMV of Charitable Remainder Trust Funded with 10,000 Shares
of Stock |
$100,000 |
$100,000 |
-- |
| Initial 5 % Income Payout from either (quarterly) CRUT - 7.2% AFR or
Taxable Account |
$5,000 |
$5,000 |
$5,000 |
Income Tax Deduction for Initial Contribution to CRUT
(which may be used to offset subsequent taxes) |
$26,427 |
$26,427 |
$0 |
| Capital Gains Tax Paid when CRT Diversifies $100,000 Stock |
$0 |
$0 |
-- |
| Total of All Taxes Paid on 10,000 Shares in Newly Diversified $100,000
Account |
$0 |
$15,840 |
$25,840 |
A CRT strategy won't solve all of Jeri's options problems, but it does
offer a way to control social capital that otherwise would default to the
tax system. Of special concern to professional tax advisors is the AMT penalty in this case study, seek competent counsel to avoid these tricky issues.
Jeri has a strong sense of community and she wants to
encourage her girls to become active in projects that address issues that
affected their family. A combination of a CRT, donor advised funds
and ongoing family meetings helps Jeri decide how to meet her philanthropic
goals.
Gift and Estate
Planning Services
Springfield, IL 62703-5314
217.529.1958 -- 217.529.1959 fax
VWHenry@aol.com
on the web at gift-estate.com
© 2000 -- Vaughn W. Henry
Other articles with options in the planning Diversifying Investments and Incentive
Stock Options and the CRT, Funding Your Retirement.
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