A recent post on Janet Novack’s Taxing Matters blog talks about executives rushing to cash in stock options before tax rates go up. Novack cites academic research indicating executives are likely to take this approach, and anecdotal evidence that it is already happening. Chances are that many of these executives will regret that choice.
Higher tax rates
We’re talking here about nonqualified stock options, the type where you pay tax on compensation income when you cash in your profit. In the following analysis we’ll assume you’d pay 35% income tax and 1.7% Medicare tax if you cash in this year. The rates you’ll pay if you continue holding the option aren’t certain, but we’ll assume the rates provided by current law, which would be 39.6% income tax and 2.6% Medicare tax (after a 0.9% increase takes effect in 2013). Cashing in this year allows you to pay tax at an overall rate that’s 5.5 percentage points lower. From another perspective, you’ll pay 15% more tax on your profit if you wait (42.2% is 15% more than 36.7%). These figures may make it seem that you’re better off taking your option profit now.
Good planning?
Let’s walk through an example where you hold an option to buy 1,000 shares at $25, and the stock is currently trading at $40. The option still has five years until it expires, but you’d like to cash in your $15,000 profit at today’s lower tax rates.
To see whether this is a good idea we have to compare the outcomes in two different scenarios. In one, you continue holding the option for a period of time before cashing in and paying tax at higher rates. In the other, you cash in the option now, pay tax out of the profits, and invest what’s left. We’ll assume you either invest the remainder in the same stock that’s covered by the option, or invest in something else that happens to provide the same investment performance, so that we can isolate the effect of this planning decision. In this “exercise now” scenario we’ll assume you sell this other investment, paying tax on any subsequent gain, at the same time you would otherwise have cashed in the option in the delayed exercise scenario.
Which approach works better? The answer depends on how the stock performs during the period between now and the time you would otherwise cash in the option. If the stock price remains the same or goes down, the “exercise now” strategy will come out ahead. But even a modest increase in the stock value will make you wish you’d continued holding the option. For example, if the stock price rises 20% during this period, delayed exercise will leave you with $2,352 more in after-tax dollars.
How does this happen? When you continue holding the option, a 20% increase in the stock price means $8,000 more in before-tax profit (the stock price goes from $40 to $48). Exercising now would leave you with less than $10,000 invested (you paid 36.7% tax on a profit of $15,000), so the 20% increase in the stock price nets you less than $2,000 in additional profit. The tax savings from exercising now are nowhere near large enough to overcome what you lost in pre-tax investment profits.
Bear in mind that this large differential springs from just a modest increase in the stock price. If the stock happens to pop during this period, doubling in price, the strategy of exercising the option now would cost you over $15,000 in after-tax dollars. Exercising the option now merely to capture today’s lower tax rates is a short-sighted approach that has a good chance of costing you a lot of money.
Predicting stock performance
As I said earlier, the winning strategy depends on how the stock performs in the subsequent period. This leads many people to believe they should determine their strategy based on their view (or their advisor’s) of how the stock is likely to perform in the near future.
Let me offend everyone equally by saying this to both the executives who hold stock options and the advisors on whom they rely: your judgment about how the stock is likely to perform in the near term, which includes the next several years, is worth exactly zero. The executive may have insights into the company and the industry in which it operates, but these provide no advantage in predicting the stock’s performance. (In my experience, this knowledge is actually a disadvantage to the executive, preventing an objective evaluation of the stock’s prospects.) The same is true for the professional advisor’s training in analyzing securities and the economy. A skilled analyst may have a slight edge that would become apparent after many choices were made over a period of many years, but near-term performance of a particular stock is largely random. You don’t know which way the stock is going to move because no one knows. It’s foolish to base an investment strategy on guesswork, and when it comes to stock performance in the near future, that’s all you have.
Key considerations
A sound approach to determining when to exercise a stock option focuses on two main considerations. The first is whether the option is ripe for harvesting, and the second is the option holder’s need for diversification. These subjects are explored in my books on the subject: Consider Your Options for option holders, and Equity Compensation Strategies for professional advisors. Here’s a brief summary.
Stock options have two kinds of value. The cash value, (also called intrinsic value) is pretty obvious: this is the profit you would have if you exercise the option and sell the stock. Less obvious but also important is the time value, which can provide an advantage over holding other investments. We saw this advantage above, where the option produces much more profit than an alternative investment that might be made after cashing in. When you exercise an option, you capture the cash value but also destroy the remaining time value. This means an option is ripe for harvesting when the remaining time value is small in comparison with the cash value.
These factors are far more important than the potential tax savings of cashing in early. In the earlier example, the option had $15,000 of built-in profit and also likely had something like $5,000 in time value (a figure that varies depending on several factors). Cashing in the option destroyed this $5,000 in time value, while producing tax savings of less than $1,000.
The other important issue in these decisions is your need for diversification. We can’t predict which way the stock price will move, and have to take into account the possibility it will decline. Many option holders are overexposed to the stock of the company where they work, and should consider cashing in options to diversify even when this means destroying some time value.
Because of the many variables at play, there are no easy rules of thumb that will tell you when to exercise an option. Focus first on whether the option is ripe for harvesting and the importance of improving your diversification. Use the change in tax rates as a tie-breaker if the decision is otherwise closely balanced, but don’t let it push you into an option exercise that doesn’t make sense.
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Kaye: I agree in general with the major points you raise; however I see a few areas where your analysis can be sharpened.
First, the increase in tax rates faced by some executives could be higher than your example. If you exercise in 2010, you have no phase-out of itemized deductions or personal exemptions – and these may return in 2011 and forward. In addition, the income from exercising options could throw you over the $250,000 threshold in 2013, thus causing your passive income to be taxed at 3.8%. And for those not in an AMT situation in 2010 there is the possibility that you might be subject to AMT in 2011 and later.
Second, the “early exercise” example should be presented as a break-even situation. Using your figures, the stock price would have to climb to about $41.50 in order to break even by exercising in later years at (your calculated) higher tax rates. That’s only a 4% rise in stock price, and this confirms your point that a modest price jump overwhelms the tax savings. Be sure to caution readers that this gain is excluding dividend payments. So, a stock yielding a 4% dividend has to generate an 8% total return to overcome the tax drag. I wouldn’t exercise an option 5 years early in that situation, but I would certainly consider exercising one or two years early. Especially if I had other tax factors making the tax rate difference greater.
One such factor could be AMT. For an executive who is about to exit the AMT phase out zone in 2010, he may enter a brief window where his marginal tax rate goes down to 28%. The attached link to an FPA article describes this AMT “window” well, but in the context of a Roth conversion. The same situation applies if you are exercising NQ options. (For this guy in the 28% bracket, the breakeven is an 8% price increase. This is more than we would expect a 4% dividend stock to grow in two years).
http://www.fpanet.org/journal/BetweentheIssues/LastMonth/Articles/UsingtheAMTtoLockInTaxSavings/
Overall, I agree with your points. But the tax increases might be higher than presented, and the breakeven point may be lower when you factor dividends into the equation. Each individual will have to run the numbers for themselves, and you have laid out the appropriate framework that should be used.
Best wishes.
All true, Andy, but as you say, these details don’t affect the main point. I didn’t present a breakeven point because it would differ for every option (it depends on the ratio between the exercise price and the stock value at the time of exercise). I simply wanted to illustrate how the leverage in a stock option can overpower the tax savings one might expect to achieve by exercising early. It doesn’t make sense to throw away $5,000 of option value for $1,000 in tax savings, and if the actual tax savings turn out to be $1,200 or $1,400, it still doesn’t make sense. Anyway, who besides you and me has the attention span for those added details?
Kaye: A good article in terms of pointing out trade-offs, and would tend to agree that the destruction of the option value created by early exercise may often outweigh any benefits of lower tax rates. Hoewver, the article seems to miss the readily available tools that exist to value options on a before tax basis, and then simply apply the tax rate before and after the proposed change. For example, one can use such tools to calculate the before tax value on 12/31/10, and apply the 35 % tax rate to that figure to find out its real after tax value. Then it is a simple matter to see see if the reduction in value due to the higher tax rate in effect on 1/1/11 is more or less than the loss of option value that would occur with immediate exercise (e.g. the reduction from the calcuated option value to the intrinsic value).
I also note that while you say above that “the winning strategy depends on how the stock performs in the subsequent period” this is actually not the case since the value of an option today does not depend on the future stock price trend as such but rather on the volatility of the underlying stock, as well as other factors such as interest rates and the time to expiration. Thus when making the calcuation referenced in my first paragraph, one need not make any assumption about future share price at all to come up with the right answer.
Thanks for the comments, coalie. Apparently everyone wanted my article to be longer, in this case referencing option valuation tools. I have some doubts about how easy it is for people without specialized training to use them properly, and in any event the decision may not be as simple as comparing the tax savings with the time value, as other factors such as the need for diversification (or the reverse, a desire to maintain this investment) can come into play.
I intended the reader to understand that when I say “the winning strategy depends on how the stock performs in the subsequent period” I was talking about how things would look from the vantage point of hindsight. As the rest of the article makes clear, I’m warning against using that notion as the basis for choosing a strategy because there’s no way to know in advance how the stock will perform.
Kaye: the article that Janet Novack wrote has a reference to data showing that executives increased their exercise of stock options in 1992, then decreased them in 1993. While there may have been excessive destruction of option value (as you describe in the note), I would expect to see that exact pattern of behavior from financially rational individuals. If you are sitting on a portfolio of 10-year options (many executives receive an option grant each year), your strategy may be to exercise each vintage just before expiration. In January 1992, these executives exercised the options that would expire in January or February 1992. Once the tax hike was certain enough, they exercised their 1993 vintage one year early….then didn’t exercise any options in 1993. As my previous post indicated, the value destruction from exercising one year early can easily be overwhelmed by tax savings. An even larger tax hike (such as the one in 1993) could drive you to exercise two years early.
Don’t be shocked to see executives evaluating an early exercise of their 2013 options today. In December 2010, those options will have only 25 months until expiration. And if their personal tax situation suggested a tax rate difference (2010 vs. 2013) larger than the 5.5% in your example, exercising early may be very sensible. However, I wouldn’t think any vintages beyond 2013 would come into play….unless diversification issues drove the decision.
Coalie: you need not run the Black Scholes model to value your options. For those that expire within about 2 or 3 years, LEAPs will provide real-world values for you. Examples:
DuPont closed at $43.38 today. You can sell a $35 option call expiring in January 2013 for $10.60 today. That implies about a 5% cumulative appreciation over 30 months.
ExxonMobil closed at $60.97 today. You can sell a $45 option call expiring in January 2013 for $18.48 today. That implies about a 4% cumulative appreciation over 30 months. (Actually the bid/asked spread is $17.40 – $18.20, so the implied appreciation is even less).
Pfizer closed at $17.17 today. You can sell a $10 option call expiring in January 2012 (no market for 2013′s) for $7.30 today. That implies about a 1% cumulative appreciation over 18 months.
The options market is valuing these in-the-money options, and the strong message is “exercise today” if your tax rate will climb significantly in the next two years or so. The value destruction seems to be fairly minimal when the options are well into the money and the expiration isn’t far off.
Best wishes.
Andy, I would agree that exercise is likely indicated for an option that’s deep in the money and close to expiration. Such an option is likely ripe for harvesting in any event, and the change in tax rates is just an added nudge in that direction.
You’re misinterpreting option values, however, when you say a particular value implies a particular amount of appreciation. While the concept is counterintuitive, the market price of an option has nothing to do with expected appreciation of the stock. An article I published last year lays out an explanation:
http://www.fairmark.com/execcomp/09061102-option-value.htm
The only sense in which option values incorporate expectations about the stock is that the current stock value figures into the value of the option, and current stock value reflects investors’ expectations for the stock.
It will be interesting to see whether executives on their own take any actions related to company stock sales or exercises of nonqualified stock options to accelerate income into 2010. In many case when you run the numbers, unless you were planning to sell the stock or exercise in 2011 or 2012, it just takes a small increase in the stock price to cover the higher taxes. As a quick rule of thumb, if you think your stock price will go up more than the percentage increase in taxes (5% increase from 20% from 15%), then wouldn’t it make sense not to sell if only considering the immediate tax concerns? There are some useful articles on http://www.myStockOptions.com in the Financial Planning section that look at this analysis. See http://bit.ly/c2jIN4
Compared to the prior era when taxes went up, the disclosure rules are much stricter for executives and companies on their stock sales. It could have a dampering impact compared to the studies mentioned back in 1992. The SEC disclosures in Form 4 and in the proxy statement may be something they want to avoid, as they will attract attention and questions. However, this is counter with the increased focus on the need to diversify and minimize the concentration in company stock.
Bruce, thanks for stopping in and offering some useful observations. I’ll take exception to one point, though. I try to discourage option holders from acting on the basis of how they expect the stock to perform, for the simple reason that they have no way of knowing how it will perform. Added knowledge about the company gained by being an executive doesn’t help in this regard, nor do the skills of a professional stock analyst. A strategy based on someone’s forecast of how an individual stock is going to perform in the short to medium term is unsound because it’s built on a guess about something that’s essentially random.
I recommend myStockOptions.com to those who can’t quench their thirst for knowledge on this subject with all the free materials on this site. Many of the articles there are available only to those who pay for premium membership, however. Wouldn’t you rather spend money on one of my books?
Kaye, Your books on a wide range of tax subjects and your website are valuable resources. You’re a gifted writer on complex tax topics and I recommend them, too.
Thanks for you for recommending http://www.myStockOptions.com Some of the most useful tools on the site, such as the myRecords portfolio tracker for stock options, restricted stock, and SARs, and the stock option calculator, are free (See myTools for description at http://bit.ly/d35z5D ), as are selected articles, FAQs, and the glossary.
As for your point about “A strategy based on someone’s forecast of how an individual stock is going to perform in the short to medium term is unsound because it’s built on a guess about something that’s essentially random” makes logical sense. I find there are various approaches to developing a stock option strategy, some of which are highly logical and reasoned, such as using some variation of Black-Scholes, and others are more based on setting personal goals for the gains based on price targets.
Both can be satisfying to the employee or executive that feel the grant has provided value to them. Please take a look at the article I have written Preventing Irrational Decisions About Selling Company Stock Or Exercising Options
at http://bit.ly/bcW3Oq (it’s free on myStockOptions.com without even registration). It takes a behavior economics approach to developing a strategy for options with the key message that you need a plan of some kind.
No problems with any of that, Bruce. And let me add that the cost of a paid subscription on myStockOptions.com is trivial compared with the cost of a planning mistake that might be avoided by spending time there. It’s an excellent value for those who want exposure to diverse ideas on a complex topic. (The comment at the end of my previous message was intended to be tongue-in-cheek.)