Finance & Accounting Mar 1, 2008

Exer­cis­ing Options

Should you accel­er­ate income tax pay­ment on share-based compensation?

Based on the research of

Robert McDonald

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.

Sec­tion 83(b) elec­tions
Under the U.S. Inter­nal Rev­enue Code of 1986, an employ­ee or ser­vice provider can choose to be taxed for restrict­ed prop­er­ty, includ­ing restrict­ed stock grants, in the fis­cal year in which the grant was made rather than wait­ing until the restric­tions lapse (i.e., the stock shares vest). The recip­i­ent must file the elec­tion with­in thir­ty days after the grant is received. The stock grant is then taxed based on the fair mar­ket val­ue of the shares at the time they are grant­ed, sub­tract­ing the amount paid for them, if any. For restrict­ed stock grants, com­pa­nies can require or pro­hib­it employ­ees from mak­ing an election.

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 (= / ) 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.

About the Writer

Joshua Moses, MBA Candidate 2008

About the Research

McDonald, Robert L. (2003). “Is it Optimal to Accelerate Payment of Income Tax on Share-Based Compensation?” Kellogg School of Management working paper.

Read the original

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