Getting your pay in stock or options rather than cash has become a lot more desirable since the top tax bracket rose to 39.6% while the capital-gains rate remained a fixed 28%. Nonqualified stock options, the most common kind, are still taxed as ordinary income, but incentive stock options, which are taxed as capital gains, may get more popular. And some new trends--such as the growing use of stock awards tied to performance and the ability to transfer options--could create new opportunities to exploit this capital-gains gap of almost 12%. If you're one of those lucky executives who receives stock or stock options as part of your pay, you might want to step back and reconsider your options.
To help high-paid executives offset the tax hike, companies may start granting more incentive stock options (ISOs). Companies generally don't like ISOs because they can't write them off as a compensation expense and they must meet certain criteria--the employer can only give $100,000 a year, and ISOs must be granted at fair market value, for example. But to make up for higher taxes, "ISOs are going to become a lot more popular because of a 12% difference between ordinary gains and capital gains," says Martin Nissenbaum, a tax partner at Ernst & Young.
To pay the lower tax, you have to hold onto the stock for at least two years if you exercise right away. The cherry on the cupcake is that ISOs are not assessed the newly increased 1.45% Medicare tax. But time the sale of your shares carefully. Profits from their appreciation could trigger the alternative minimum tax. If that looks likely, consider selling some of your options early. This creates a "disqualifying disposition," where you lose the capital-gains treatment. But paying ordinary income tax is still better than paying the AMT, says Mike Kesner, head of compensation and benefits at Arthur Andersen. And you still avoid paying the Medicare tax.
ISOs may be a better deal for employees than nonqualified stock options, which are taxed as ordinary income. But companies prefer NSOs because they can write them off and they don't have to worry about any restrictions. NSOs can be granted and exercised in whatever amount and whenever the company chooses. Hence some companies may decide to pile on extra NSOs, rather than grant ISOs, to make up for higher taxes, says Matt Ward, an executive compensation consultant at Wyatt & Co. However, there is still a way to exploit the capital-gains gap: Once you exercise NSOs, any further appreciation or depreciation is a capital gain or loss. So if you can, consider exercising your NSOs early.
STICK AROUND. If your company gives you actual stock rather than options, there's another way to take advantage of the capital-gains gap. You may have restricted stock, or stock that is gradually vested to you over time in order to keep you loyal. Since all you have to do to get it is stick around for a set period, restricted stock is sometimes called the "living and breathing incentive," says Matt Ward, a compensation consultant at Wyatt & Co.
As a result, restricted stock has come under increasing criticism, and companies are starting to turn to performance shares instead, or stock that is set aside for executives contingent upon their meeting certain company goals--anything from increasing market share to making certain acquisitions. As the goals are met, the stock gradually becomes vested until the executive owns it. This is a better deal for employees than options, says Ward, because when the stock underlying your options drops, the options become worthless. But when you own the actual stock, it retains some value even when its price goes down.
BIG RISK. Another plus for performance shares is that there's an easy way to lower the tax bill--but not without risk. You can elect to pay ordinary income on restricted or performance shares before they have time to appreciate, thus realizing any future profits as capital gains. To do this, you must apply to the IRS for an 83(b) election within the first 30 days of being granted the stock. This lets you pay income tax on the difference between the grant price and the market value of the stock immediately, as if it had vested. Where the grant price and market value are the same, by all means make the 83(b) election because you won't owe any taxes, says Arthur Andersen's Kesner. "This usually only happens in a private-company situation," he says. Public companies more commonly give you a discount because you could buy the stock at market value yourself.
You take a big risk with an 83(b) election, however: If you don't meet the stated goals, or the stock drops, you lose the money you have put up to pay the taxes right off the bat. Hence Kesner advises only executives in startup, turnaround, or potential explosive-growth situations to risk it.
Down the line, benefits specialists expect a tremendous rise in the use of performance-based stock and stock options. Until now, most companies have shied away from them because they create a charge to earnings, says James McKinney, an executive compensation consultant at Hirschfeld, Stern, Moyers & Ross. But if the Financial Accounting Standards Board has its way, in 1997 stock options, which currently cost companies nothing to grant, will also be charged against earnings in annual reports. "This will increase use of performance-based options because there will no longer be a penalty attached to them," says McKinney. The FASB has asked companies to footnote the cost of stock options in their financial statements as of Jan. 1.
Shareholder outrage over excessive executive compensation is already leading to a small but growing use of performance shares and has caused the Securities & Exchange Commission to require that companies state the value of stock options in proxy statements. An additional nudge comes from a provision in the new tax law that limits to $1 million how much executive compensation a company can deduct unless that pay is linked to performance. If the FASB's ruling goes through, performance shares will make more sense for companies to use than options because they will be less dilutive and less expensive, says Wyatt's Ward.
All these pressures to assign an actual value to stock options could conceivably lead to an even more advantageous tax break. That is, you could give stock options to your children without having to worry about paying any estate or gift taxes.
For this to work, the Internal Revenue Service would have to recognize that unexercised options have a taxable value--something it does not currently do. But with all the regulators demanding the valuation of options, and with a number of existing methods to do so, the IRS may acknowledge them. In that case you could transfer options before they have a chance to appreciate.
Currently, most options can't be transferred to anyone else except through a will or estate. In the rare instance where companies allow executives to give unexercised options to family members, the executive must still pay income taxes on any appreciation when that relative uses the options to buy the stock.
NEW OPPORTUNITY. But if unexercised options were taxable, you could pay taxes on them immediately and pass them and all their potential growth to your children. Not only would your children pay capital gains instead of the enormous cost of estate and income taxes, but you would pay very little tax up front and remove all that appreciation from your estate.
It would work somewhat like an 83(b) election: Say your company gives you options to buy 1,000 shares at $10 each, but the stock is worth $20 a share, or $20,000. You would pay ordinary income tax on $10,000, pass on the options to your children, and a year later, they could sell and pay the lower capital-gains tax on the other $10,000--or more if the stock appreciates. You may have to pay a small gift tax if the value of the options exceeds $20,000.
Such a possibility is still speculation but with the rules for stock options in flux, new opportunities to exploit the capital-gains gap may surface. And if you are diligent you may find that although you now have higher taxes, you also have some more lucrative tax breaks.
EINCENTIVE STOCK OPTIONS: These may be better for executives than the nonqualified kind. They are taxed at the capital-gains rate if you sell, as long as you hold them for at least two years. But their appreciation could trigger the alternative minimum tax.
ENONQUALIFIED STOCK OPTIONS: Companies prefer these because they get a tax break. NSOs are more flexible than incentive options, but gains are taxed as ordinary income when you exercise them.
EPERFORMANCE STOCK AND OPTIONS: Increasingly companies will be using these, which are gradually vested to the employee as corporate goals are met.
E83(b) ELECTION: This strategy allows you to pay income taxes on restricted or performance shares right away. Any appreciation will be taxed as capital gains.
ESTOCK OPTION TRANSFERS: Down the road, you may be able to pass on unexercised options to someone else without paying gift or estate taxes.
DATA: BUSINESS WEEK
TABLE: CAPTURING THE CAPITAL-GAINS EDGE Incentive Nonqualified stock option stock option EXERCISE PRICE $25 $25 FAIR MARKET VALUE AT SALE* 55 55 GAIN 30 30 TAXED AT 28% CAPITAL-GAINS RATE -8 -- TAXED AT 42% ORDINARY INCOME RATE** -- -13 AFTERTAX BENEFIT 22 17 INCENTIVE STOCK $5 a share OPTION ADVANTAGE or 29% *Assumes stock appreciates at 12% per year for 6.5 years **Includes 1.45% Medicare tax DATA: ARTHUR ANDERSEN & CO.