Generally, stock options issued to employees are either Nonqualified Stock Options (NSO) or Incentive Stock Options (ISO). Employees receiving NSOs or ISOs could possibly realize a tax reduction with stock insurance through buying put options.
ISO
ISOs receive preferential tax treatment by the IRS, so employees with ISOs have less to consider when making decisions regarding the stock options they’ve received or exercised. Employees receiving ISOs are generally granted options to purchase a company’s stock after a certain vesting date for a certain price, and after the vesting date the employee may exercise the option by paying the company the option price for the stock. In general, ISOs only pay taxes after selling the stock for a profit.
NSO
Employees granted NSOs on the other hand may be required to pay taxes when the options are granted if a fair market value can be determined or when the options are exercised if a fair market value cannot be determined at the date of options grant. With NSOs, even though the employee has only received a paper profit at option grant or option exercise, the taxman (IRS) must be paid upfront.
Purchasing Put Options
If the stock of an employee with ISOs or NSOs is publicly traded, it may be possible to hedge stock or acquire stock insurance by purchasing publically traded put options traded in the options market and thereby delaying and possibly realizing a tax reduction.
Example #1
Suppose an employee had been granted 1,000 NSOs expiring in ten years for Microsoft, with an exercise price of $1 back in the 1980s before Microsoft became a public company. And let’s suppose after Microsoft Corp. (NASDAQ: MSFT) became a public company the price of the stock had risen to $27. At this point, the employee had a big decision to make; he/she could purchase the stock for $1,000 and then turn around and sell the stock for $27,000 for a nice profit of $26,000, and also pay the taxman (IRS) a large portion of the profit. But, if the employee is desiring to hold onto the Microsoft stock for additional price appreciation, to delay paying the taxman, and to have some stock insurance in the event the stock were to drop significantly in price, he/she might consider buying stock insurance by purchasing put options for the stock. Suppose the price for a put option for Microsoft at a strike price of $25 for the next month’s expiration is $.05, the employee could “insure” the position in Microsoft for $50 (1000 shares * $0.05), costing 0.19% per month or 2.3% annualized (does not include brokerage fees and commissions).
Example #2
Over his career, a terminally ill former employee of General Electric Co. (NYSE: GE) had been granted and exercised 20,000 ISO shares of General Electric stock and he desires to postpone selling the shares until after his death in order for his heirs to realize a tax reduction benefit from a step-up in basis. The shares of General Electric represent a significant portion of the employee’s personal stock portfolio and he is concerned the General Electric stock may drop in value before his death. The former employee desires for the General Electric stock to be sold after his death, but he is seeking to insure against a drop in the price of the General Electric stock before his death. Suppose the price of GE stock is currently trading around $34 and the price of a put option for next month’s expiration with a strike price of $30 currently has an ask price of $0.05. The retiree could purchase stock insurance for the General Electric stock for one month for $1000 (20,000 shares * $0.05), representing a cost of 0.15% or 1.8% on an annualized basis (does not include the cost of brokerage fees and commissions).
Example #3
An employee of Google Inc. (NASDAQ: GOOG) has 1000 shares of Google stock acquired through an ISO. The employee only has one more month until the gain from selling the Google shares would be considered a capital gain instead of ordinary income, hence by waiting one month to sell his/her Google shares the employee may realize a significant tax reduction, but the Google stock is highly volatile and the employee is anxious the stock might drop in price during the next month. The current price for Google stock is trading around $370. The employee cold buy stock insurance by purchasing put options for the next month’s expiration at a strike price of 330 for $2.80 per put option for a total cost of $2,800 (1000 shares * $2.80, does not include brokerage fees and commissions) representing a cost of 0.76%. The cost of the Google stock insurance in this example is expensive compared to the previous examples because the Google stock has been highly volatile, making the cost of the insurance “expensive”, but the $2,800 insurance premium paid for one month’s stock insurance is relatively small compared to the potential tax reduction from waiting one month to sell the Google shares.
Disclaimer
The information provided in this article is for informational purposes only. Power Financial Group, Inc. makes no claims as to the accuracy of the information included in this article and you should consult your tax advisor for further details.
[tags]tax reduction, stock insurance, personal stock portfolio, hedge stock[/tags]