Financial Planning: Year-End Planning

Richard Friedman
The Ayco Company
Albany, New York

	If company stock awards have changed, planning may need to change too Review strategy if stock price recovered this year; consider state rates as well as federal Take advantage of special Roth IRA conversion in 2010

Many companies have made changes in their long-term incentives, including stock awards, over the past year or so. This is in the context of reduced cash bonuses and payouts from performance plans, and other compensation cutbacks. Should this change someone's planning? Possibly, particularly if the company has changed the mix of equity awards, introduced new types of awards (e.g. restricted stock or RSUs in place of options), made special retention grants or off-cycle awards, offered a stock option exchange, or offered employees a choice in their next equity award. Not only does the employee need to become familiar with any new awards, but this may affect strategies of when to exercise stock options or sell company stock.

With most companies' stock prices higher now than a year ago, an option exercise strategy is worth updating and reviewing. Whether to exercise this year or early next year, or to hold off, will be a function of stock price and estimates of appreciation, as well as tax rates. And any tax rate analysis should really be a two-to-three-year analysis. That is, federal income tax rates are scheduled to remain the same for 2009 and 2010, but then adjust upward in 2011 (assuming no further action by Congress).

An individual should do a two-year tax-rate projection to estimate when an option exercise might make more sense. This may not necessarily be the determining factor of when to exercise options (or whether to defer compensation), but it should be considered. If an individual's taxable income is lower this year, e.g. due to a lower bonus earlier this year or no payout from a long-term performance plan, it might be the right year to exercise options.

In addition to federal taxes, state tax rates need to be considered as well. Approximately a dozen states have increased their tax rates this year, and at least two more will increase tax rates next year. If an individual worked in more than one state during the term of the option, he/she should review with their tax advisor the rules relating to what is taxable by their state of residence, as well as what might be taxable by a nonresident state. Several states have increased their audit activity in this area.

Another tax factor, unrelated to projected compensation, might be the Roth IRA conversion opportunity available to everyone beginning next year (this year, only taxpayers with AGI below certain limits may make the election). Individuals who make this election pay taxes on the taxable portion of the IRA or 401(k) plan that is converted. But for elections made in 2010 only, taxes may be spread over the two following years (when tax rates are scheduled to be higher) or paid in 2010. This could have an impact on a stock option exercise strategy. An in-service withdrawal from a 401(k) plan to accomodate a Roth IRA conversion could, in certain situations, affect that individual's ability to elect net unrealized appreciation (NUA) tax treatment for a subsequent distribution of company stock from the 401(k) plan. Speaking of 401(k) plans, review whether the company has placed restrictions on the amount of company stock owned in the company plan. We are seeing more companies adopt such restrictions—and a few companies even eliminate company stock as an investment alternative.

Hank Zapisek
Financial Network Investment Corporation
San Diego, California

	Consider sales to diversify and get 15% capital gains rate With ISOs, year-end AMT moves depend on stock performance Exercise NQSOs early in the year to max out Social Security tax, allowing greater take-home amounts later

Company stock: Every investment plan calls for adequate diversification to reduce risk while capturing a positive return. A review should be made to determine the ratio of company stock to your total investment portfolio. If the ratio is deemed too high, then sales must occur to bring to the ratios back in line. Another goal is to minimize taxes by selling company stock that qualifies for the lower 15% long-term capital gains tax. Thus, you must sell stock held longer than one year, in most cases. Higher capital gains tax rates are in our future, and now may be the time to keep more of what you have earned. Therefore, review your ratios and minimize the taxes on any sales by choosing company stock that has aged enough to qualify for favorable capital gains treatment.

Incentive stock options: Review your option grants to determine if you should exercise in the first few days of 2010. If you exercise and hold the ISO stock early in the year, you can avail yourself of two key strategies. First, if the stock price does not perform to your expectations during the year, you could sell the stock before December 31 to disqualify the ISO and thus avoid the issue of alternative minimum tax (AMT). Secondly, if the stock price does perform well, you could sell the stock in the following year in time to create the cash to pay for the AMT and get long-term capital gains treatment.

Nonqualified stock options: A subtle strategy could be to plan your NQSO exercise in the first quarter of 2010 to help meet the maximum limits for Social Security tax withholding. In this way, you could realize greater take-home amounts later in the year.

Sheri Iannetta Cupo
Sage Advisory Group
Morristown, New Jersey

	Avoid overconcentration Sell restricted stock at vesting; flip ESPP shares Know what happens upon various job events and life events

Casually date your company stock; don't fall in love with it. Minimize the concentration of wealth tied to your employer, especially if you get annual grants. Yes, this means that eventually you will have to sell stock. And, yes, the price could go up after you sell. But it could go down too. Don't risk it. If you own company stock and hold employee stock options and you need to reduce your concentration, then sell the shares you own before exercising options. The options have leverage and act like a "no cost" loan from your employer.

When restricted stock vests and the net shares are delivered to your account, sell these shares. You already took the tax hit.

Flip your ESPP shares. You are in your employer's ESPP because it offers a lookback period and a 15% discount, right? If so, when the shares are delivered into your account, sell them to lock in the discount.

Never be surprised at tax time. Have your advisor prepare a tax projection, especially if you've sold stock or exercised options. Ensure you are safe-harbored by adjusting withholding or making quarterly estimated payments. Then set the money aside in a savings account that you need for the tax bill before you start investing or funding goals.

Know the Black-Scholes value of your options. If there is not much difference between the Black-Scholes value and the in-the-money value, don't risk a bird in hand (the in-the-money value) for a little upside (the time value, or the difference between Black-Scholes and in-the-money values).

In these uncertain times, understand what happens to your equity compensation plans if you retire, are laid off, die, are disabled, or leave voluntarily. Don't leave money on the table for you or your family.

Robert Pyle
Diversified Asset Management
Boulder, Colorado

	Reverse dollar cost averaging can overcome personal investment biases Net gains and losses with a diversified outside portfolio Consider hedging to reduce risk in a concentrated position

The past two years have proved to be a very trying time for individual investors. The overall market was volatile, and some individual stocks were even more volatile. Behavioral finance biases play a big part in trying to diversify away from company stock. The familiarity bias leads you to overweight stocks where you have some familiarity or local knowledge. Another is called self-attribution bias, which leads you to attribute success to expert knowledge but failures (losses) to randomness or things beyond your control. Helping clients to realize that they have these biases will make them more successful investors.

To combat these investor biases, we have been creating plans for reverse dollar cost averaging. We try to set up a schedule for the client to follow to reduce exposure to company stock. First we look for possible tax losses on ESPPs. Then we work on NQSOs and ISOs. I would like to see a 25% gain from the strike price of stock options before we think about exercising them.

We figure out how many years remain until the options expire and then multiply by four quarters. Then we set up a schedule to sell shares in approximately equal increments each quarter until the options expire. This method allows the client to dollar-cost-average out of a large position in company stock and move into a more diversified portfolio. Finally, if the client has a gain in ESPPs, they can sell some of these shares and offset them with capital losses in their taxable account.

For year-end planning, look to net gains and losses of company stock with a diversified outside portfolio. For example, if you have losses in your diversified portfolio, look to sell company stock with gains to net out losses and gains.

When someone sells, I look at ESPP shares first because you can net gains and losses out to minimize taxes (see above). The options have more chance of a large return because of the leverage factor. With restricted stock, I would sell in equal increments on a quarterly basis to get to zero exposure at retirement.

Another new development allows investors to hedge their vested employee stock options by selling call options and using their options as collateral (for details, see the articles Hedging Employee Stock Options (Part 3) and Options For Your Options elsewhere on this website). In the past, if investors sold call options, they were considered naked options that needed much larger margin requirements. The new law allows investors to use employee stock options as collateral (though the employer must consent).

If clients absolutely have to keep a large concentrated position, they should hedge their positions buy buying puts and selling call options, thus creating a collar to help minimize volatility. We show them the effect of having a concentrated position, and the risk it imposes to their financial plan, with a financial-planning software program. We try to nudge them to have zero exposure to their company stock when they retire and no more than 5%–10% before retirement.

Jason Papier
Fluent Wealth Partners
San Jose, California

	Expect higher taxes in 2011 Consider selling no later than 2010 for current lower rates Year-end 2009 may be an optimal time to exercise and sell

In 2011 we will likely see the rate for long-term capital gains rise from 15% to 20% (a 33% increase) and marginal rates for the wealthy rise from 35% up to perhaps 45% (a 28% increase). Many executives will therefore decide to so a same-day sale in 2010 to capture those lower tax rates. An argument could be made, depending upon a person's marginal rate, that the executive should consider selling a portion this year and a portion next year, rather than selling all next year, in order to lock in an even better average tax rate. In fact, with the possible health-care surtax on the rich, it may be further argued that 2009 is the best year to exercise and sell options if exercising could trigger the surtax in 2010.

John C. Lawson
AM&M Financial Services Inc.
Rochester, New York

	Be realistic and opportunistic amid volatility Consider future tax increases, stock plan changes, and regulatory shifts Know what happens upon change of control or job termination

Realistic and opportunistic: the volatility in stocks over the 12 months since fourth quarter 2008 spotlights the need for executives to be constantly connected and flexible in realizing the greatest value in their employer stock awards, a challenge for most in the blur of other priorities. Advice regarding when and how to liquidate employer stock awards after the rebound in 2009 remains much the same as that rendered in the dark at the end of 2008. While each executive's decisions will be a function of unique personal financial facts and circumstances, common considerations include:

• employer share ownership requirements and culture
• employer and SEC trading restrictions
• outlook for employer stock
• for stock options, the remaining time value as measured by the relationship between the current spread and the years left to expiration
• potential for repricing/exchange of stock options before existing grants expire
• tax planning, including harvesting losses and the outlook for federal and state rates (income tax withholding upon taxation of stock awards is at mandatory federal (25%) and state rates, so withholding may well understate liability)
• wash sale rule implications, i.e. grants of, and lapsing of restrictions on, employer stock awards are "acquisitions"
• personal investment time horizon and risk tolerance
• prudent investment portfolio diversification and rebalancing, e.g. a concentration of personal net worth in employer stock and retirement benefits from an unfunded, nonqualified source may suggest a conservative allocation of investment portfolio
• future employer stock awards (type, timing, and expected value), e.g. stock options at Black-Scholes value vs. restricted stock at projected total return vs. restricted units at projected total return (but with credit risk) vs. long-term incentives with multi-year performance metrics
• Vesting, forfeiture, and term truncation upon separation from employment, change in control, and shareowner-voted bankruptcy
• Estate plans, including charitable giving of appreciated employer stock

Executive compensation remains under intense scrutiny from numerous interested parties, often with conflicting interests, such as the US Congress, the IRS, the Federal Reserve, the SEC, ISS, employees, and shareholders, as well as spouses and former spouses. This has important implications for:

• restricted stock/units and multi-year performance plans replacing stock option grants
• performance vesting and performance-accelerated vesting replacing time-lapse vesting
• increasing teeth in forfeiture, clawback, and other recourse provisions
• change-in-control provisions adding triggers and reducing benefits
• 10b5-1 arrangements with shorter terms to allow for accommodating changes in outlook and culture

Executives should check for updates to change-in-control provisions, and consider opportunities to renegotiate employment agreements regarding severance and SERPs.

Scott Barbee
Truepoint Capital
Cincinnati, Ohio

	Sell concentrated positions Harvest losses from other holdings Consider GRATs

As every client situation is different, specific recommendations should be made by a competent professional who has a complete understanding of the client's circumstances. That said, there are some basic strategies everyone should consider.

• Selling concentrated company stock positions when possible, even if it means recognizing substantial capital gains. Actively harvesting the rest of the diversified portfolio for capital losses to offset those gains can go a long way to reducing the annual tax bill.
• Selling concentrated company stock positions that have been held more than one year even if there aren't losses to offset the recognized gains. At 15%, the long-term capital gains tax rate is low. At least for the near future, the rate will certainly not be lower than it is now. And though the potential increase to long-term capital gains rates under the Obama administration may have to be placed on hold until the economy rights itself, a future increase is still a threat. But be mindful of the potential impact of AMT.
• In circumstances where clients may still have some room in the 15% ordinary income tax bracket, don't overlook the possibility of recognizing gains to take advantage of the 0% capital gains rate which applies to that bracket.
• Assuming financial circumstances permit, continuing a regular plan of annual exclusion gifting of stock to family members affords clients the opportunity to move more shares to them than in recent years, without necessarily worrying about transfer tax issues. With a rebound in that stock, more appreciation could be shifted to those family members.

Under the right circumstances, clients can consider a more involved strategy, such as creating a grantor-retained annuity trust (GRAT) to shift future appreciation to other family members with little or no immediate transfer tax cost. If the expectations for the company are high, but the current company stock price is significantly depressed, a GRAT may provide a tremendous opportunity to transfer wealth. The current low-interest-rate environment also enhances the attractiveness of executing a GRAT currently.

Alan Ungar
Critical Capital Management
Calabasas, California

	Don't sell depressed stock unless you need to Wait to exercise options Sell restricted stock at vesting and ESPP shares at purchase Don't speculate about future tax rates

If you are holding company stock whose value has declined, even after the recent upturn, this is not a good time to sell unless you must have the money. Right now losses are paper losses. By selling, you actually take a loss. The only other reason to sell occurs if you have substantial gains and want to offset the gains with losses (assuming there is a loss).

Exercising stock options while the price of the stock is down is not a good idea. The only advantage of options is their leverage. If prices are down, then leverage is up and so it would be a mistake to exercise now. The only advantage of exercising when the stock is down is that taxes would be less, but it is generally bad policy to let the tax tail wag the investment dog.

For restricted stock, NQSOs, and ESPP shares, I most always recommend that they be sold immediately. This because they are taxed, and I see no reason to exacerbate the risk. For the options: exercise and sell those with the least leverage.

Regarding employee stock purchase plans (ESPPs), and depending on the company and ESPP structure (such as the purchase discount), this is probably a good time to stop. The reason that at least part of the spread is taxable as income and the employee may end up having to hold the stock while it is going down. Generally (and I emphasize generally) it is better to sell those shares as soon as possible.

The guiding principle for all these decisions is your portfolio. When an employee receives some restricted stock it makes sense to sell it as soon as possible even if the market is down. The employee is being taxed on the total amount as if it were income, and so it makes sense to realize that income and not wait for the stock to go up.

The possibility of increases in tax rates should not play a role in planning. It's too hard to anticipate what is going to happen with rates and stock prices.

Lee McGowan
TFC Financial Management
Boston, Massachusetts

	Wait to exercise NQSOs Manage risk instead of making assumptions about future prices Offset gains with losses

The current market conditions and economic environment have given more reasons to plan for year-end and prepare for the years ahead. It is time for investors to take a step away from their investment account statements, from television's talking heads and market prognosticators. It is time for investors to gather their wealth management team in order to assess all aspects of their financial plan and focus on their goals and objectives. Along those lines, a thoughtful and proactive client contacted me recently to discuss his investment strategies, including his restricted stock and nonqualified stock options in the context of his overall financial plan.

The client has been diversifying out of his restricted stock and nonqualified stock options for the past few years and has enjoyed tremendous upside. The client has realized more than $2 million in capital gains from his restricted stock sales. He also has a significant cash position. Unfortunately, the client's remaining restricted stock and options, and other equity investments, have dropped and risen recently along with the market. The client asked a question: "Should I be exercising more options since the stock price is still below its high?"

The client was prepared to exercise his options by selling shares to cover the cost (cashless exercise) or pay cash for the cost of the options. He is bullish on his stock long-term and would like to understand if there is a benefit to exercising the options and holding the shares. His CPA, Dennis LaPorte of UHY Advisors, and I discussed the issue and each analyzed various scenarios.

Dennis LaPorte ran scenarios based on a cashless exercise using future assumptions of stock price and tax rates. Does it make sense to exercise options via a cashless exercise and hold the stock (paying tax at capital gains rates rather than exercising and paying ordinary income tax rates on future appreciation)? He found that, despite the difference in ordinary income tax rates and capital gains rates, it makes sense that the client should not exercise the options and hold the stock.

I ran scenarios based on the client paying cash for the option cost (including income tax). After reviewing the client's overall investment portfolio and cash needs (for living expenses and a new business venture), I advised the client against exercising his options and holding the stock due to the leverage advantage of the options, his liquidity needs, and the diversification benefits of holding cash (versus using the cash to exercise his options).

I shared the following simplistic scenarios with the client to exaggerate the point:

Scenario 1: Pay $2 million in option cost to exercise the options, and the stock goes to $0. If the stock goes to $0, then he has lost his $2 million cash investment and the options are worthless.

Scenario 2: Take no action, and the stock goes to $0. If no action is taken, he maintains his liquidity and diversification (reducing his equity market risk). His options are worthless, but he has maintained his $2 million cash position.

The client was satisfied with the advice from his wealth management team to preserve his liquidity and maintain his investment diversification while taking advantage of the leverage in his stock options. We did not show him additional illustrations of the long-term consequences of the potential transaction. At this point, given current market conditions and the client's needs, it was important to manage the investment risk and discount assumptions about his company's future stock price.

In addition, the client has $2 million in realized capital gains from his company restricted stock transactions this calendar year. We are working through a tax-loss realization program to offset as much of the gain as possible. The losses in the portfolio are unfortunate, but as another article on this website mentions, we must turn the lemons into lemonade.

The financial advisors who submitted written remarks to myStockOptions.com for this article were not compensated for their contributions. The statements made in this article do not constitute personal investment advice and may not apply to your individual circumstances. Consult a financial advisor directly to obtain guidance on your personal financial situation.