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In Focus #70: June 9, 2009


Financial Advisers in Motion; A Primer On the Employment Issues Facing Those in Transition


Retirement Income: Repairing the Damage to Assure the Flow


Train Wrecks of Estate Planning


A Complex Game: The Life Settlement Process
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Financial Planning Mistakes Begin to Blossom; Consider the Bad Advice Regarding Employee Stock Options


s a "Millennium Prediction", I predicted that brokerage firms increasingly would make mistakes as they ventured into financial planning areas. One and one-half years into the new millennium, we clearly have witnessed those mistakes with respect to employee stock options.

The range of mistakes has been wide. For example, we have seen brokerage firms fail to exercise employee stock options, letting them expire worthless. Additionally, we have seen brokerage firms not understand basic principles, such as the fact that certain employee stock options are taxed upon exercise of the options. Finally, once stock options have been exercised, we have seen errors involving investment management, such as failing to diversify concentrated positions, failing to hedge (for example, through the use of options) and recommending the use of margin to pay taxes or other expenses with the value of the shares as collateral. These errors have been especially egregious when dealing with volatile, technology company shares.

No doubt, employee stock options are complex. But brokerage firms, in their effort to be a "one stop shop" for all financial needs, expressly hold themselves out to the public as being more than traditional stockbrokers. They do so in many ways, such as on their websites and in their advertisements. For example, one major brokerage firm runs advertisements proclaiming its expertise not only in investment planning but also in "Tax Strategies", "Estate Planning" and "Protection Strategies". Another major brokerage firm runs advertisements announcing that it offers "a host of financial services". These include planning with respect to "tax management strategies" and "wealth transfer strategies".

Indeed, brokerage firms not only hold themselves out as having this expertise, some firms have special groups in-house to so advise. In one matter involving faulty employee stock option advice, the brokerage firm's Executive Compensation Group advised the client as to the best strategy for his employee stock options.

Given the multitude of errors on the part of brokerage firms, employees with stock options need to be aware of the significant tax liabilities that can result from exercise of the option, as well as the subsequent holding and sale of the underlying shares of the company. Here are three basic points to remember.

First, there are two types of employee stock options, and they are treated very differently. The most common type is the non-qualified stock option ("NQSO"). The other type is called a qualified stock option, and it also is known as an Incentive Stock Option ("ISO"). Employees, and their brokerage firms advising them, need to know that the exercise of an ISO is not a taxable event (unless it results in taxation as a result of the Alternative Minimum Tax, or "AMT"), but the exercise of a NQSO certainly is a taxable event. The employee exercising the NQSO is taxed on the difference between the strike price of the option and the fair market value of the stock on the date the NQSO is exercised. Importantly, the difference is treated as ordinary income, and employee must pay ordinary income tax rates (not capital gains tax rates).

Second, when non-qualified employee stock options are exercised, the issuing company withholds taxes. However, often the percentage withheld only is 28%. That is a potential problem, because in many cases, the exercise of the NQSO places the employee in a much higher tax bracket, as high as 39.6%. Employees need to know that the withholding will be insufficient and that, as a result, they may need to pay substantially more in taxes simply due to the exercise of the NQSO. Well-advised employees direct the issuing company to withhold a greater percentage for taxes.

Third, when employees sell their NQSO shares, which they received when they exercised the option, they do so at either a gain or a loss. That gain or loss is measured by the difference between the market value at the time of exercise and the market value at the time of sale. If the shares were held one year or less, the gain (if any) will be taxed at short-term capital gains rates. Otherwise, the gain (if any) will be taxed at the more favorable long-term gain rate of 20%. By comparison, when employees sell their ISO shares, they are taxed at the long-term capital gain rate so long as they held the shares more than 2 years from when they received the ISO and also held the shares more than 1 year from when they exercised the option. Additionally, note that taxes are based on the difference between the strike price of the option (not the market value at the time of exercise as with the NQSO) and the market value at the time of sale.

Beyond those three basic points, there are numerous strategies and considerations to properly examine NQSOs and ISOs. These include the Alternative Minimum Tax ("AMT") with ISOs, disqualifying dispositions with ISOs, and reverse vesting / Section 83(b) elections with both ISOs and NQSOs. Brokerage firms need to understand those strategies and considerations, since they hold themselves out to the public as possessing such expertise.

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James J. Eccleston is a securities attorney, representing investors as well as brokers and brokerage firms nationwide in arbitration, litigation and regulatory matters. He is the immediate past co-chair of the Chicago Bar Association's Securities Law Committee, the immediate past chair of its Financial and Investment Services Committee, a registered investment advisor and a licensed securities principal of the National Association of Securities Dealers (NASD). He can be reached at 312-641-2929.




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