posted on November 15th 2016 in LA/OC CFP Team Posts with 0 Comments /

Back in the 1980s, it seemed only Fortune 500 executives received stock options.  

Boy, have things changed! Today, employees of many firms, large and small, have received stock option grants.  

When it’s over, it’s over

In most cases, employees have up to 10 years to “exercise” their options and thereby capture the economic value.  

But all that changes when your employment ends. If you’re planning to leave your employer, you should carefully consider the effect on your options.  

Reading two major documents is important:  

  1. The plan document spells out the broadest possible parameters for options under the plan. For example, it may state that option grants may allow participants to pay the cost of exercising the options in several different ways, such as payment in cash, in stock, or by having a stockbroker put up the cash for immediate exercise and sale.
  1. Your individual option grant document spells out your particular rights and limitations. For example, it might require you to pay for the options in cash only, even though the plan could permit a wider range of methods. Also remember that each of your grants may have different vesting schedules or other provisions.  

Usually, when you voluntarily leave an employer, you have 90 days post-termination to exercise your options. If you wait too long, they will expire worthless! To determine this deadline, you have to read the plan, as well as each grant.  

The time available for exercise can be much longer if you’re leaving because of retirement, as defined in the plan. Retirement may be defined differently for stock options than it is for pension or other benefit plans, so be careful. (The options usually remain exercisable longer in the event of death or disability, but we don’t usually volunteer for those conditions.)  

Are you a special case?

Be alert for specific rules that may apply to you in the documents referenced above.  

If you join a competitor, for example, your options might immediately lapse.  

And if you are terminated for cause, unexercised options may be forfeited.  

Senior executives, particularly in large public firms, should be especially careful about “bad boy” clauses, which  can trigger immediate forfeiture of options in the event of criminal conviction, or as a result of actions deemed immoral or harmful to the firm’s reputation (typically as determined by the firm’s board). Punitive clauses like this might make you think twice about concealing a bottle of wine in the picnic basket you take to a free concert in the park. This example may seem overly cautious, but it should prompt you to consider your relationship with the board before inviting its judgment of you.   

Capturing ISO tax breaks

Some special benefits can be obtained through Incentive Stock Options (ISOs).  These qualify for better tax treatment, but only if both you and the plan follow the rules. These rules are complex, and narrowly interpreted, so be careful with ISOs.  

The general concept of ISOs is that the income you receive will be taxed as capital gains, rather than ordinary income on your W2, if at least two years pass between grant and sale of the shares, and at least one year passes between exercise and sale.  

The tax law limits how many ISOs your employer can grant to you each year, and requires you to be an employee, not a consultant, at the time of grant. Also, ISOs can only be exercised while you are an employee or within 90 days of termination.  

When better can actually be worse

It’s crucial to note that since ISO rules are part of the tax law, if you or your employer modify your option grant, it’s very easy to inadvertently lose the tax break.  

For example, let’s say you initiate a friendly departure from your employer.  Imagine the company asks you to delay it somewhat. In exchange, you ask that the vesting of your options be accelerated, or your exercise deadline extended.  

If the company agrees to modify your options, get professional advice as to the tax consequences before agreeing to the modification. Per the IRS, “any change in the terms of an option which gives the optionee additional benefits under the option” is treated as the grant of a new option. So even if the grant paperwork still references the original grant date (to determine vesting and expiration), the IRS treats the options as having a new grant date.  

If the modification takes effect only upon your termination, you are no longer an employee at that moment, and the IRS could potentially argue that your options are no longer ISOs (which can only be granted to employees). Tax counsel should advise you on this.

Even if this new grant still meets the overall ISO rules, the two-year clock starts over again. You could unwittingly lose the favorable tax treatment very easily by selling within two years of modification.  

Also be careful if you’re asked to stay on as a 1099 consultant, with loosely defined duties, to ease your transition out of the firm. As noted above, the IRS says you have only 90 days after termination of employment to exercise and retain ISO qualification, and  this sort of 1099 retainer situation is probably too loose for you to be considered an employee under the tax law. (The IRS can deem contractors to be employees, based on certain tests, but those are designed for cases where the firm has the power to control exactly what those people do, and when, where, and how they do it.)  

As a result, if the company extends your exercise deadline to 90 days after the 1099 consulting contract ends, that’s fine. They’re still options. But the IRS will only give you the capital gains break if you exercise them within 90 days of terminating employment. Since consulting doesn’t count as employment, your ISOs will stay qualified only if you exercise them during the first 90 days after your true employment ends. After that date, they quietly transform into non-qualified options.  

There are plenty of other ways to lose the ISO tax breaks, but this discussion is just highlighting a few scenarios relevant to termination of employment.  

Bottom line: be very, very careful requesting modifications to ISOs. And observe the timing requirements carefully!   

Choosing to lose ISO tax breaks

There may be good reasons to intentionally choose to let ISOs transform into non-qualified options. For example, perhaps the alternative minimum tax resulting from exercising ISOs and holding the shares would be too onerous, so a disqualifying disposition is in order. Or you simply can’t tie up your cash for a year between exercise and sale. These are important considerations, but beyond the scope of this article.  

Converting your ISOs to non-qualified options could be intentional, but should never be accidental.  

Choosing not to exercise your options

In most cases, when you terminate employment, you should exercise all options before they expire. It rarely makes sense to walk away if they have any current value at all.  

However, walking away might be the right thing for you, given your situation.  

For example, there might be significant restrictions on your ability to sell. This is common with privately held firms, and it may also be the case for certain insiders at publicly traded firms. If you can’t get your cash out with acceptable likelihood, or within an acceptable time period, it is possible that exercising and holding the shares would bring more risk than you are willing to bear.  

Remember, an option offers a choice, and you don’t have to exercise it.  

Tying it all together

In summary, if you are leaving your employer and have unexercised stock options, please take the following steps, as a starting point:

  1. Exercise all options before expiration, in most circumstances. It rarely makes sense to walk away if they have any current value at all. However, walking away might be the right thing for you to do if there would be significant restrictions on your ability to sell.  
  2. Read the option plan document to see the general limits on your time frame and other actions available to you. You can get this document from your human resources contact at most firms.  
  3. Read the individual option grants, looking for tighter time constraints and more restrictive limitations than the overall plan allows. Don’t just assume you still have all 10 years to exercise them. Note where these grant documents differ from each other, and from the overall plan document.
  4. Come up with a plan for payment. This could be cash, shares, “cashless exercise” or borrowing against your other assets if all else fails.  
  5. Carefully review the tax law governing ISOs to avoid inadvertently disqualifying those shares (i.e., losing the capital gains treatment retroactively) if you plan to pay by handing over shares you received from previously exercising other ISOs.
  6. Come up with a plan for sale. This is typically for non-insiders at publicly traded firms, but can be a real issue in other cases.  
  7. Read any shareholder agreements if your firm is privately held, as these could severely limit your ability to sell. (You may have signed these coincident with your first options grant or stock purchase. Or they may be referenced in the plan document.) The cash or assets you tender to exercise the options could be tied up for a very long time, depending on the restrictions. Also, valuation may be a contentious issue, and could affect your planned sale timing, depending on the situation.  
  8. Closely involve your tax and financial advisors if you are considering any modification to your option grants, especially if they are ISOs.  

You’ve got a friend

You could probably benefit from having an experienced options strategist look at this with you, and boil it down to your key action items.  It’s best if your advisor can go beyond just the tax and financial aspects, to understanding what risks are appropriate for you to take, and your view of the stock’s future prospects.  

I’ve been advising Fortune 500 executives and other employees on stock option issues for over 25 years.  I’ve also quietly advised many clients in the Byzantine maneuvering and negotiations that often accompany friendly and not-so-friendly departures from firms of all sizes. My partners also have deep, relevant experience.  

If you need a reality check, or hands-on guidance from someone who can bring it all together for you, talk to your WorthPointe advisor. We’re happy to help!  

about the author: WorthPointe Wealth Management

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