Exercising Options

Though the glamour surrounding stock options and other share-based compensation dissipated with the bursting of the tech bubble at this millennium’s outset, these employee incentives are still in place for many executives. Few of these executives, however, understand the special tax treatments associated with stock option and restricted stock grants. Kellogg School of Management’s Professor Robert McDonald has rigorously examined the optimal timing of tax payments on options and stock grants in his 2003 paper entitled “Is it Optimal to Accelerate the Payment of Income Tax on Share-Based Compensation?” In this paper he demonstrates the error in the common belief that it is generally optimal from a tax perspective to exercise these stock options and restricted stock grants early when the underlying stock is expected to appreciate in value.

The basics of option grant and restricted stock taxation are as follows: in the case of an option, its value is typically taxed as ordinary income when the option is exercised. If the employee decides to hold on to the stock after exercise, future gains or losses are taxed at the more favorable capital gains rate. In the case of restricted stock grants, these grants are taxed as ordinary income when they vest. However, the owner of the grants can make a Section 83(B) election when the restricted stock is granted. The taxpayer then pays ordinary income tax on the value of the stock at the time of the grant, and pays a lower capital gains tax on the stock’s capital appreciation when it vests. Figure 1 illustrates the tax liability scenarios described above: when employees take full ownership of options by exercising them or are granted restricted stock compensation, any gain to that point is taxed as ordinary income; subsequent gains or losses in the stock’s value are taxed at a lower capital gains rate.

Figure 1: Taxation on Share-Based Compensation

Intuition suggests then, that it may be financially prudent to accelerate payment of ordinary income tax on such compensation if the employee expects the value of the stock to appreciate over time. After all, isn’t it better to opt for early exercise, so that expected future gains are taxed at the lowest possible rate? If employees were to defer their ordinary income tax payments by taking full ownership later rather than sooner, they would have to pay income taxes on the full future value of the stock upon its liquidation, a tax liability that will generally be higher than if the capital gains rate were applied to some of that gain. However, McDonald shows that early exercise is essentially never optimal under the following condition: the employee has paid nothing for the options or stock grants in the first place, which is often the case when executives receive stock-based compensation.

 
Why You Should Not Accelerate Tax Payments on Share-Based Compensation
 
The mistake of accelerating tax payments to avoid future ordinary income tax payments on a higher-priced stock is based on a fundamental misconception that the employee has been granted a full share of stock. From an economic perspective, this is false; only a fractional share (one minus the marginal tax rate) has been granted because the ordinary income tax that will inevitably be taken out at some point represents a portion of the stock’s value that the employee can never access.

This realization has several consequences. First, once it is evident that one has only been granted a partial share of stock, it becomes clear that accelerating your ordinary income tax payment on the position is simply bad timing. The tax payment—if the marginal tax rate is 40 percent—is 40 percent of your stock position whether it is paid today, tomorrow, or several years from now. Strictly from the perspective that money paid tomorrow is less valuable than money paid today, surrendering 40 percent of your stock position for taxes today should be more costly than surrendering it tomorrow. Additionally, accelerating your payment of ordinary income taxes on these grants actually adds another layer of taxation to your position. Imagine these two scenarios: you can pay 40 percent on your position today and a capital gains tax rate on the growth of your remaining stock position, or pay 40 percent on your position in the future without having to pay taxes on capital appreciation. In either case, we are starting with 0.6 shares for every share granted. However, in the former scenario, we are taxed beyond the 40 percent ordinary income tax.

Some of the arguments for accelerating tax payments have arisen when borrowing money in order to pay the tax has been employed as a strategy. You would probably hold back on early exercise in the event that you would have to sell a portion of your shares in order to pay the tax. However, once you can borrow money in order to pay the tax, it appears that the question is whether the future tax savings are outweighed by the interest expense incurred on the borrowed funds. For this reason, arguments for early exercise often hinge upon expectations regarding the stock’s future performance. Even if the taxes are paid in cash though, it can be demonstrated that a portfolio can be built that will always outperform early exercise. The expected performance of the stock is therefore irrelevant.

Assuming that you can borrow money and trade in the stock in question, this portfolio is one in which the money borrowed to pay the tax is used to re-invest in the stock instead. Specifically, given a capital gains rate of C and an income tax rate of T, you should purchas additional shares. For example, in the context of 15 percent capital gains and a 40 percent income tax bracket, you should purchase 0.29 (=[0.40 – 0.15] / [1 – 0.15]) additional shares. This portfolio of the unexercised stock position and additional shares is a strictly dominant portfolio over one constructed by taking early exercise and paying the resulting tax with cash on hand. In essence, since borrowing money to pay the tax is equivalent to borrowing money to re-invest in the stock— by paying the tax in cash, you avoid having to liquidate your position—it makes more sense to avoid early exercise, but still borrow money and buy stock, than it does to do the opposite.

But What About . . .

Given the simplicity and soundness of this logic, why does much of the available information on early exercise and election reinforce peoples’ flawed intuition, pushing them toward early tax payment on options and granted stock? Published arguments for early exercise cite reasons such as “losing faith” in an employer’s prospects (and thus their stock’s value), diversification to mitigate risk, the penalty of moving into a higher tax bracket for waiting to exercise options, and locking in a low cost basis for non-qualified options.

Some of these arguments are easy to dismiss. If you have lost faith in your employing firm, you might consider negotiating cash compensation in lieu of options; better still, you could leave your current employer for one with better prospects. Diversification is an important goal and it may even be a rationale for early exercise—so long as it is understood that this move destroys value. The argument about marginal tax brackets makes sense only if you can be certain your income will increase substantially in future years. Otherwise, the advice to accelerate tax payments is tantamount to suggesting that you strive to make less money.

Exceptions to the Rule

Despite the broad application of McDonald’s guidelines for avoiding early exercise, there are certain situations in which this course of action, or an 83(b) election for share grants, may be justified. If you have a restricted portfolio and can neither purchase nor sell shares, and money can be borrowed to pay the tax, early exercise and accelerated tax payment may be a good idea. Doing so effectively allows you to purchase more shares of the stock when you would not normally have been permitted to. As mentioned above, early exercise and tax payment may also be worth considering for the purpose of diversification, particularly if no other opportunity for selling company shares to raise capital (e.g., shorting) is available. Expected changes to your expected marginal tax rate will have an effect on this decision as well. If tax rates are expected to increase, early exercise and accelerated tax payment may be optimal. Lastly, the presence of dividends on the shares may have an effect if one possesses restricted stock grants. McDonald proves in this case that early exercise is never optimal as long as the tax rate on dividends is greater than the tax rate on capital gains. It is clear, however, that these exceptions can only be correctly interpreted from the standpoint that the reasons why early exercise is generally not optimal are understood.

Avoiding a Lemming Mentality

So, why do even financially savvy people make errors in judgment with regard to early tax payment on share-based compensation? As discussed here, it is perhaps because early exercise makes intuitive sense at first glance. McDonald tells of a consultant friend who faced precisely this question of when to exercise options. The consultant even built a spreadsheet modeling his decision, but doubted his data-driven conclusion which was clearly against early exercise. Only after hearing a comprehensive explanation did he understand the logic behind the argument: a fractional share is always a fractional share, regardless of when one pays the tax.

Simple mistakes like tax acceleration can keep you from realizing the full value of your pay package. You should avoid a lemming mentality by examining your alternatives carefully and seeking advice as needed to gain a more complete, and ultimately profitable, understanding of your financial situation.