Corporations have been providing stock options for years to key executives as part of an employee benefits package. Although stock options come with the potential to accumulate significant wealth, clients grapple with a number of concerns when planning for the exercise of stock options.
The availability of funds to exercise the options, the timing of their taxation, restrictions on transferability, and transfer taxes are all concerns that advisors and clients frequently don't address. However, planning for stock options can be straightforward. And the applications of life insurance–insuring debt, covering estate tax exposure and providing liquidity to exercise inherited options–can be extremely helpful in overcoming client concerns.
Qualified Stock Options
A qualified option, the most common type, is referred to as an incentive stock option. The ISO typically is taxed as capital gain holdings when the stock is sold, not when the stock option is received or exercised. For holders to benefit from delayed taxation and capital gain tax rates, they must meet holding requirements and transferability restrictions.
When a corporation provides a qualified stock option to an employee, it does not receive a corporate expense deduction when the employee is taxed at the sale of the stock unless there is an early disposition of the stock (holding the stock for less than one year). If so, the executive's gain will be taxed as ordinary income as opposed to capital gain; the corporation then can take an expense deduction in the amount of the gain recognized by the executive.
Qualified stock options are also not transferable and therefore gifts of the stock options cannot be made to another party. Options can be transferred outright only at death.
Common Complaints of Owning an ISO
Two common client complaints of owning an ISO are the cash required to exercise the option and the cash required to pay taxes on the stock's gain.
Borrowing funds–The client can finance the exercise of the option through a bank or other third-party lender. The lender will require collateral for the loan and will typically not accept the stock as collateral. If margin requirements are applicable, an early disposition of the stock may be necessary to reduce debt, resulting in undesirable tax consequences.
Cashless exercise–An alternative funding approach is the cashless exercise of the options in which the executive short-sells the shares. Unfortunately, the transaction is subject to ordinary income taxation and brokerage fees.
Taxation–The gain on an ISO is taxed at capital gain rates when the stock is sold. The gain is calculated based on the difference between the option price and the fair market value of the stock. However, the client must hold the option for at least one year to receive capital gain treatment.
