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Too often I hear from financial advisors that their clients are considering exercising their non-qualified employee stock options (NQSOs) early (i.e. several years prior to expiration) and holding the shares for at least 1 year to get long term capital gains tax rates when they sell the shares. This may seem like a reasonable tax strategy, but it really isn’t and here’s what clients need to know.

Unlike Incentive Stock Options (ISOs), NQSOs are NOT tax advantageous. They are taxed as ordinary income when they are exercised. For example, if 1,000 NQSO shares granted at $10 are fully vested after 4 years and the stock price is now $60, $50 per share or $50,000 would be taxed when the grant is exercised.

Keep in mind that one of the benefits of non-qualified stock options is that the recipient can defer paying any taxes on the spread (i.e. current stock price minus grant/exercise price) prior to expiration by simply not exercising. The other benefit of employee stock options is that due to a fixed exercise price, they have leverage. Option leverage means that when the company stock price goes up by a fixed percentage (i.e. 20%) the in-the-money or intrinsic value of the option will increase by more than 20%.

For example, if the NQSO granted at $10 currently has a company stock price of $11, a 20% increase in price to $13.20 would yield $3,200 for the 1,000 shares and a percent change in value of 220% (($3,200-$1,000)/1,000*100). Be advised that the leverage percentage will decrease as the current stock price gets larger and the option gets deeper in-the-money. In this example, if the stock price is now $100 a 20% increase yields only 22.22% gain in value.

Leverage is an important consideration when exercising stock options because exercising (i.e. buying the shares at the option price) eliminates the remaining leverage in the option. Held (i.e. long or owned) shares DO NOT have leverage. If the stock price goes up by 20% the value of the shares also goes up by 20%. The leverage analysis within the client deliverable (page 6) is very effective at explaining this important concept to company stock and option recipients.

Since NQSOs have no tax advantages like ISOs which aren’t taxed at exercise, exercising and holding NQSOs is hard to justify for tax or investment reasons. This is because by doing so the recipient is paying the tax early and they are trading leveraged options for non-leveraged shares. A good way of determining when to exercise NQSOs so as not to eliminate too much upside leverage and be exposed to downside leverage if the stock price declines is to understand the option’s Insight Ratio.

Exercising NQSOs and selling the shares has a variety of benefits.  In addition to tax deferral and leverage retention, the proceeds from the sale of the shares can be applied to the exercise price and withheld for taxes. Otherwise, these costs have to come from other funds on hand.

The final benefit of NOT exercising and holding NQSOs (if these others aren’t enough) is risk reduction.  Most equity compensation recipients have the tendency to accumulate high levels (over 20%) of concentration in their company stock and options. Exercising NQSOs, selling the shares and reinvesting the proceeds creates diversification which in turn reduces risk. Concentrated company stock and options positions are inherently risky because decreases in stock prices will have a substantial negative effect on the client’s net worth.

The bottom line is that exercising and holding NQSO to get long term capital gains tax rates may seem like a good strategy but it’s a numbers NO NO.

Bill Dillhoefer is the CEO of Net Worth Strategies, Inc. He’s been providing equity compensation guidance to financial advisors since 2000. Connect with him on LinkedIn or on Twitter

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