Financial Planning: Year-End Planning

The 2010 Tax Relief Act, the result of a much-discussed compromise between President Obama and Congress, was enacted in December 2010. It extended the 2010 tax rates through 2012. Given the current political stalemate in Congress and the presidential election ahead in 2012, it is unlikely that tax rates will change in 2012. This should simplify your financial planning at the end of 2011.

Even if tax rates eventually rise, or if tax reform leads you to pay higher taxes, many experts say that tax rates should never be the only reason for exercising or selling at the end of the year. As part of your year-end and year-beginning tax planning, review your stock options and company stock holdings. Make investment objectives and personal financial needs, not tax considerations, the driver of your decisions. Here are 10 ideas to review before the end of the year to make sure you aren't paying more taxes than necessary.

Editor's Note: See also related articles on year-end planning with restricted stock/RSUs and employee stock purchase plans.

Alert: If you are tempted to sell appreciated stock before the end of the year, you may also be concerned about the wash sale rule. However, the rule applies only to stock sold at a loss. This means you can sell the stock at a gain and quickly repurchase without wash sale problems.

1. Consider the time value of tax money on an NQSO exercise. If you are convinced that higher tax rates are ahead, it usually still makes sense to wait on paying any taxes (i.e. not accelerating income into the current year). However, if you were planning to exercise in 2012 or 2013, then you want to see if this traditional strategy of deferring income to future years still applies in 2011 (see the relevant article series elsewhere on this site).

Social Security Rate Is Lower

The most meaningful provision in the 2010 Tax Relief Act was the 2% cut in the Social Security tax rate, from 6.2% to 4.2% (Medicare remains uncapped at 1.45%). This reduced the Social Security tax maximum from $6,621.60 to $4,485.60, a savings of $2,136 ($4,272 for married couples). If your annual income is under the Social Security wage-base maximum ($106,800 in 2011 and $110,100 in 2012), then exercising NQSOs before the end of 2011 will let you benefit from this 2% reduction, as the Social Security rate will return to 6.2% in 2012 if Congress does not continue it. (The cut may indeed be extended through 2012, though in 2012 the Social Security wage base will rise to $110,100.)

Delaying Exercises To January

By law, your company must withhold at least the applicable flat rate of federal income tax on the exercise of your nonqualified stock options. This can create a tax-deferral strategy if the flat rate is less than your marginal tax rate. Waiting to exercise nonqualified stock options (NQSOs) from December of this year to January of next year may let you invest the funds that will be used to pay some of the tax for almost an additional year.

The rate for supplemental income tax withholding, including income from NQSO exercises and restricted stock vesting, is 25% (35% on yearly supplemental income over $1 million). In a December exercise, the additional tax will be due four months later, in April. But in a January exercise, payment of the additional tax can be deferred for 15 months, until the April of the following year. For those who are in the 35% tax bracket this year and are fortunate enough to expect $1 million in supplemental income early next year, the advantage of waiting to exercise is lost.

Estimated Taxes

If income from your exercise will be subject to tax at a higher rate, but your total withholdings will equal or exceed one of the estimated tax safe harbors—either 90% of the current year's tax liability or 100% of the prior year's liability (110% if your adjusted gross income for the prior year was over $150,000)—the excess tax needs to be paid only when your return is due in April. High-income taxpayers will continue to see less reduction in personal exemptions and certain itemized deductions, as the phaseout has dropped (the Obama administration's tax proposals would reverse this). This could change your calculation of whether you need to pay estimated taxes.

If you are not yet within a safe harbor, consider asking your employer to withhold extra taxes from your paycheck to cover the shortfall at exercise (or restricted stock vesting). The IRS also credits withholding taxes as if they were withheld equally throughout the year. This can retroactively remedy tax underpayments from earlier in the year and avoid a potential underpayment penalty.

2. Calculate the alternative minimum tax (AMT) when deciding when to exercise ISOs and NQSOs. If you are considering exercising incentive stock options (ISOs) before the end of the year and holding the stock, make sure you or your tax advisor first prepares an AMT projection to see whether a tax benefit may arise from waiting until January of the following year. Because of the 2003 tax law (the Bush tax cuts), taxpayers at higher levels of income are even more likely to be subject to the AMT.

If you also have NQSOs and are thinking about exercising them early in the following year, for two reasons a tax projection can help you decide whether an overall tax saving will result from exercising those NQSOs this year. First, your AMT from your ISO exercises might be so high that you can exercise NQSOs this year and essentially not pay any tax on the spread. This is because your ordinary tax may remain lower than your AMT, and the government gets the higher amount.

Second, exercising NQSOs before year-end might get you out of paying AMT and dealing with its complexities. Although the exercise of NQSOs generates regular taxable income, this might reduce your exposure to AMT by potentially making your regular tax higher than AMT.

3. Use an early-in-the-year exercise of ISOs to pay AMT later. If you will be hit with the AMT from your year-end ISO exercise and eventually will sell part of the stock to pay the tax, consider exercising those options early next year rather than at the end of this year. By exercising in January through early April of next year, you can hold the stock for over 12 months before the tax is due. You will receive long-term capital gain treatment on the sale for the full gain over your exercise price, at a maximum tax rate of 15%, and then have the cash from the sale when you file your return by April 15 of the following year. Plus, you can then also sell at the end of next year if your stock price drops significantly (look at the suggestion in the next idea).

Alert: Year-end 2011 presents a possible exception to the strategy outlined above. In 2013, the Medicare tax rate will rise to 2.35% for individuals with incomes over $200,000 and couples with incomes over $250,000. In addition, starting in 2013 a new 3.8% Medicare tax will apply to investment income, such as dividends and stock sale gains, for people in the top tax brackets. If you have incentive stock options, you may want to consider an exercise and hold in 2011 for the ISOs you planned to exercise in 2012. This would help you avoid the new Medicare tax if you intend to sell the ISO shares for favorable tax treatment after holding them for one year.

4. Avoid the impact of the AMT by selling ISO stock. If you exercised ISOs this year and the value of the shares you received subsequently declined, you may have a unique problem that may call for a unique solution.

	If you exercised ISOs and the value of the shares fell, you may face a unique problem, but solutions are possible.

Traditionally, when exercising and holding ISOs, you try to avoid making a disqualifying disposition of the shares, such as a sale or a gift, to retain the long-term capital gains tax benefits. The exercise of ISOs, however, may generate substantial AMT. Facing the AMT is usually an unpleasant surprise. Even worse, should the shares received at exercise substantially decline in value, the resulting AMT can be greater than the current value of those shares.

A disqualifying disposition of the shares before the end of the year will erase the AMT related to the ISO exercise (although you may still be in the AMT for other reasons). You may still be subject to ordinary income tax or AMT, but in some cases that tax can be considerably lower than the AMT you would have been subject to without the disqualifying disposition.

Alert: If you make a disqualifying disposition by sale after the stock received on the exercise of the ISO has gone down in value, do not repurchase company stock within 30 days before or after the sale. If you do, you may need to pay a tax even higher than the AMT you sought to avoid under the wash sale rules. Also, for the same reason, be careful not to make a disqualifying disposition by gift, contribution, or sale to a related party.

5. Make charitable donations by using appreciated stock. If, as a result of an option exercise or the vesting of restricted stock, you have securities with a low tax basis, consider making your charitable donations using those securities rather than gifting cash. When you donate appreciated stock that you have held for over one year from the date of exercise of an option, you get a charitable deduction for the full market value at the time of your donation. By gifting the securities directly to a charity or through a foundation or donor-advised fund, you also avoid the capital gains tax that would otherwise be due on the sale of the securities.

Alert: Be careful not to donate stock that you received on the exercise of an ISO or the purchase of ESPP shares until the disqualifying disposition period has passed (at least one year after exercise and two years from grant).

6. Make gifts of stock. Consider making annual exclusion gifts of stock before the end of the year. In 2011 you may make annual gifts of $13,000 ($26,000 if you split the gift with a spouse) to any number of recipients without incurring gift tax or using any portion of your lifetime gift tax exemption (but don't make a gift that subjects you to gift tax without first speaking to your tax advisor).

Gifting low-basis securities that you intend to sell has traditionally been an effective way to reduce overall family income tax. As discussed below, the lower capital gains tax rate for long-term holdings may provide an even greater income tax incentive for making such gifts.

7. Take advantage of the lower capital gains rate, and harvest losses. The long-term capital gains rate is 15% for taxpayers with ordinary income in tax brackets above 15%. (This 15% capital gains rate has been extended through 2012.) However, taxpayers who have income in the 10% or 15% bracket (up to $34,500 for singles in 2011) qualify for a 0% capital gains tax rate through the end of 2012. If you have a low-income relative, or a child who will be at least 19 years old by the end of the year in which the securities will be sold (24 for full-time students providing more than half their income), consider gifting the securities to the relative or child now and having the recipient sell the securities at his or her lower rates.

The securities sold by the child or relative must still be held for over one year (including the period you held them before the gift) to qualify for the 0% rate. Of course, after you make the gift the proceeds will belong to the recipient. But in appropriate circumstances this planning can cut capital gains taxes by more than half. For the use of this technique to fund university tuition and other educational expenses, see the relevant article on this website in the section Life Events: College Funding.

Alert: Again, be sure that such a gift does not result in a disqualifying disposition of ISO or ESPP stock.

If you have net capital gains for the year, your capital-loss carry-forwards from prior years will become useful. Consider "harvesting" losses on depreciated securities to offset those gains. Capital losses offset capital gains dollar for dollar; any excess up to $3,000 ($1,500 for married couples who file separately) can offset ordinary income. Greater net losses can be carried forward to future years.

8. Evaluate state and local taxes. If you are considering exercising NQSOs (or if restricted stock will vest) either at the end of this year or at the beginning of next year, don't forget to consider the net effect of state and local income taxes. It is possible that state and local income taxes paid this year in connection with your exercise may be allowable as an itemized deduction in determining your regular federal income tax liability. For the tax year 2011, you can deduct either your state and local income taxes or your state and local sales taxes.

If you are considering exercising ISOs next year and holding the stock, you might want to prepay state and local taxes before the end of the year if doing so will not subject you to AMT this year. Exposure to AMT can result from a deduction for such taxes in combination with any adjustment resulting from an ISO exercise. This is because state and local income taxes (or sales taxes) and property taxes are non-deductible for AMT purposes. They are therefore added back in calculating AMT income. By paying them in a year in which you are an ordinary taxpayer, you can ensure that you get the maximum benefit from this deduction.

9. Preserve gain by "selling short against the box." As the year ends, you may find that you want to protect a gain on shares obtained through an earlier option exercise or restricted stock vesting. You may be concerned about the future prospects of your shares, but you don't want to sell your shares and trigger the capital gains tax this year. If you are not a senior executive or director, and if your company or the SEC does not prohibit it, consider "selling short against the box." Under this technique, you sell borrowed securities from your broker while owning substantially identical securities that you deliver later to close out the position. ("Naked" short selling, which occurs when the trader does not own the stock, is periodically restricted by the SEC and is often blamed for the market volatility of the past few years.) Selling short against the box allows you to protect your profit and defer recognition of gain until next year, provided you close the short position before January 31 of the following year and hold shares (without any additional hedge) throughout the 60-day period after the short position is closed.

Example: You have 100 shares of stock with a value of $5,000 and basis of $2,000. You sell those shares short for $5,000 without triggering any gain. On January 18 of next year you close the transaction by buying stock in the market for $4,000 and delivering those shares to repay the shares you borrowed. On March 20 of next year (more than 60 days after you closed), you sell your original shares for $6,000. You recognize $1,000 of short-term capital gain on January 18 and a long-term gain of $4,000 on March 20.

Alert: When you close a short sale, use the trade date for gain calculation but the settlement date for losses. A short sale for ISO stock that you have not held one year from exercise or two years from grant is considered a disqualifying disposition, which you should avoid. Also, make sure you check with your company first: many companies don't allow executives, along with rank-and-file employees, to enter a short sale or any type of hedge on company stock.

10. Consider exercising options for depressed shares. Can volatile or fallen share prices ever be good? Well, maybe not good; but there may be a silver lining when you are optimistic about your company's future.

	Can depressed share prices ever be good? There may be a silver lining if you are optimistic about your company's stock.

When you exercise NQSOs, you have to pay ordinary income tax on the difference between the fair market value (FMV) of the shares at exercise and the exercise price. When you exercise ISOs, even though you are not subject to ordinary income tax, you may trigger AMT. The FMV of the stock minus your exercise price is the amount that affects the calculation of AMT.

Exercising options when the FMV of the shares is relatively low can minimize tax obligations in both scenarios, particularly with ISOs. In the case of NQSOs, this exercise also starts the timeframe for future gains to be taxed at lower capital gains tax rates.

A number of caveats apply. Do not consider this approach if the shares have fallen so far that your options are out of the money or you have better alternatives for your money. Also, this strategy works best if you intend to hold the shares and your options will expire relatively soon. Of course, investment, not tax considerations, should always govern your decisions.

This article was originally written by a former partner of a major accounting firm, where he was the National Director of Personal Income Tax and Retirement Planning. The staff of myStockOptions.com have since updated and expanded it. This article was published solely for its content and quality. Neither the author nor his former firm compensated us in exchange for its publication.