Table of Contents About This Book 9 Part I Preliminaries 11 1 Equity Compensation 13 1.1 Six Categories of Equity Compensation 13 1.2 The Central Problem 14 2 Terminology 16 2.1 Recipients of Equity Compensation 16 2.2 The Company 17 2.3 Restricted Stock Awards 17 2.4 Terminology for Stock Options 19 2.5 Option Vesting 21 2.6 Using Stock to Pay the Exercise Price 22 2.7 Stock Option Documents 24 3 Your Client s Option Inventory 27 3.1 Sources of Information 27 3.2 Vital Statistics for Stock Options 29 3.3 Other Useful Information 31 Review Questions for Part I 33 Part II Dealing with Company Stock 35 4 Risk Factors 37 4.1 Individual Factors 37 4.2 Reasons to Hold Company Stock 38 4.3 Volatility 39 4.4 Individual Stocks 40 4.5 Analysis of Individual Stocks 41 4.6 Diversified Stock Portfolios 42 4.7 Leverage 43 4.8 Liquidity Risk 45 4.9 Risk in Perspective 47 5 Managing Risk 49 5.1 Managing the Portfolio 49 5.2 Stop Orders 50 5.3 Hedging Transactions 52 5.4 Tax Issues in Hedging 55 5.5 Managing Your Own Risk 56 3
4 Equity Compensation Strategies 6 Securities Laws 59 6.1 Lockup Periods 59 6.2 Blackout Periods 60 6.3 Rule 144 61 6.4 Rule 701 63 6.5 Section 16 63 6.6 Rule 10b5-1 65 Review Questions for Part II 67 Part III Taxation of Stock Investments 71 7 Capital Gains and Losses 73 7.1 Basic Rules 73 7.2 Equity Compensation and Basis 74 7.3 Capital Loss Whipsaws 76 7.4 Identifying Shares 77 7.5 Sales to Related Persons 79 7.6 The Wash Sale Rule 82 7.7 Consequences of a Wash Sale 83 7.8 Equity Compensation and Wash Sales 85 8 Dividends and Investment Interest Expense 88 8.1 Special Rates for Dividend Income 88 8.2 Excluded Dividends 88 8.3 61-Day Holding Period 89 8.4 Coordination with Capital Gains and Losses 90 8.5 Dividends Paid Prior to Vesting 91 8.6 Investment Interest Expense 91 9 Tax Planning for Depreciated Stock 95 9.1 Terminology 95 9.2 Short-Term and Long-Term Losses 96 9.3 The $3,000 Capital Loss Limitation 96 9.4 Avoiding or Using the Carryover 97 10 Tax Planning for Appreciated Stock 100 10.1 Key Issue 100 10.2 Collateral Tax Consequences of Deferral 101 10.3 Deferring a Fixed Amount of Income 101 10.4 Deferring a Variable Amount of Income 102 10.5 Using the Analysis 104 11 Medicare Tax on Investment Income 106 11.1 Overview 106 11.2 Rate of Tax 106
Table of Contents 5 11.3 Taxable amount 107 11.4 Net Investment Income 108 11.5 Overall Income 108 11.6 Planning for Equity Compensation 109 Review Questions for Part III 111 Part IV Stock Received as Compensation 115 12 Employment Taxes 117 12.1 Withholding 117 12.2 Social Security Tax 119 12.3 Self-Employment Tax 120 13 Taxation of Stock Awards and Purchases 122 13.1 Stock Awards Without Restrictions 122 13.2 Buying Company Stock 124 13.3 Compensation Income 124 13.4 Basis of Shares 125 13.5 Categories of Restrictions 125 14 Vesting and the Section 83b Election 128 14.1 General Rules 128 14.2 Determining Whether Shares Are Vested 130 14.3 Restrictions Relating to Securities Laws 131 14.4 Consequences When Shares Are Not Vested 131 14.5 Effect of Section 83b Election 133 14.6 The Alves Trap 134 14.7 Making the Section 83b Election 135 14.8 Problems in Making the Section 83b Election 136 14.9 Restricted Stock Units 138 15 Employee Stock Purchase Plans 141 15.1 ESPP Terminology 141 15.2 Common Plan Designs 142 15.3 Nonqualified ESPPs 144 15.4 $25,000 Limit 145 15.5 Tax Treatment of 423 Plan Participants 146 15.6 ESPPs and Wash Sales 150 Review Questions for Part IV 153 Part V Stock Option Valuation and Harvesting 159 16 Stock Option Valuation 161 16.1 Intrinsic Value 161 16.2 Time Value 162
6 Equity Compensation Strategies 16.3 Elements of Time Value 163 16.4 Effect of Increasing Intrinsic Value 163 16.5 The Black-Scholes Formula 164 16.6 Option Valuation Factors 165 16.7 Range of Possible Values 166 16.8 Time Value Versus Exercise Price 167 16.9 Underwater Options 169 17 Economic Analysis of Stock Option Harvesting 171 17.1 Options in the Money 172 17.2 Options About to Expire 172 17.3 Exercising Options to Hold Stock 172 17.4 Tradeoff When Harvesting to Sell Shares 173 17.5 Comparing Intrinsic Value and Time Value 175 17.6 Estimating Time Value 176 17.7 Client s Financial Condition 177 17.8 Harvesting Part of the Option 178 Review Questions for Part V 179 Part VI Nonqualified Stock Options and SARs 183 18 Taxation of Nonqualified Stock Options 185 18.1 Basic Tax Rules 185 18.2 Capital Loss Whipsaw 187 18.3 Options In the Money; Backdating 187 18.4 Early Exercise Stock Option Plans 189 18.5 Tax Rules for Share Exchange 190 19 Stock Appreciation Rights 192 19.1 Overview of Stock Appreciation Rights 192 19.2 Economics of Stock Appreciation Rights 194 19.3 Taxation of Stock Appreciation Rights 195 20 Tax Strategies for Nonqualified Options 197 20.1 Early Exercise for Capital Gain 197 20.2 Delayed Exercise for Tax Deferral 200 Review Questions for Part VI 203 Part VII Incentive Stock Options 207 21 Incentive Stock Option Preliminaries 209 21.1 Overview of Tax Benefits 209 21.2 The ISO Inventory 210 21.3 The $100,000 Limit 211
Table of Contents 7 22 Regular Tax Treatment of Incentive Stock Options 214 22.1 Receiving or Exercising an ISO 214 22.2 Special Holding Period 215 22.3 What Is a Disposition 216 22.4 Qualifying Sales 218 22.5 General Rule for Disqualifying Dispositions 218 22.6 Income Limitation Rule Not Available 220 23 Alternative Minimum Tax Fundamentals 223 23.1 Basic Concept of AMT 224 23.2 Parallel Tax System 225 23.3 Key Elements of AMT Tax Calculation 226 23.4 AMT Tax Rates 227 23.5 AMT Exemption Amount 228 23.6 Phase-out of Exemption Amount 229 23.7 Effective Marginal Rate of Tax under AMT 229 23.8 Comparison with Regular Income Tax Rates 231 23.9 Effective Marginal Rate on Capital Gains 232 24 Incentive Stock Options and AMT 235 24.1 Overview 235 24.2 Disposition in Year of Exercise 236 24.3 AMT Adjustments 237 24.4 Implications of Capital Gain Adjustment 238 24.5 Disqualifying Disposition in Subsequent Year 241 24.6 Qualifying Sale or Disposition 242 25 The AMT Credit 244 25.1 AMT Credit Overview 244 25.2 Available AMT Credit 245 25.3 Claiming the AMT Credit 246 25.4 AMT Credit Carryover 249 25.5 Special Rule for Recovering Old AMT Credit 250 Review Questions for Part VII 253 Part VIII Tax Strategies for Incentive Stock Options 259 26 ISO Conversion Benefit 261 26.1 Conversion Benefit 261 26.2 Conversion Benefit 262 26.3 Tax Bracket 263 26.4 Exercise Price 264 26.5 Risk Profile 266 26.6 Selling Some of the Shares 267
8 Equity Compensation Strategies 27 AMT Cap on Tax Benefit 269 27.1 Selling All Shares 270 27.2 Holding All Shares 272 27.3 AMT credit balancing 274 27.4 Eliminating AMT 277 27.5 Income from Other Sources 279 27.6 Other Income in Later Years 280 27.7 Real World Situations 281 28 Strategies for Holding ISO Stock 284 28.1 AMT Risk 284 28.2 Bailing Out of AMT 286 28.3 Exercising Early in the Year 287 28.4 Tax-Free Exercise Late in the Year 289 28.5 State Taxes 290 29 Recovering AMT Credit 292 29.1 AMT Credit as an Asset 292 29.2 Time Value of Money 293 29.3 Alternate Year ISO Exercise 294 29.4 Recovering $3,000 Per Year 295 30 Special Issues in Handling ISOs 297 30.1 Using Stock to Exercise ISOs 297 30.2 Early Exercise ISO Plan 298 30.3 Gifting ISO Stock 300 Review Questions for Part VIII 303 Answers to Review Questions 307 Index 331