you accelerate income tax payment on share-based compensation?
on the research of Professor Robert
Joshua Moses '08
special tax treatments associated with stock option and restricted
stock grants can be difficult to understand. Professor Robert
McDonald examined the optimal timing of tax payments on options
and stock grants in his 2003 paper, "Is it Optimal to
Accelerate the Payment of Income Tax on Share-Based Compensation?"
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employees take full ownership of options by exercising them
or are granted restricted stock compensation, any gain to
that point is taxed as ordinary income; subsequent gains or
losses in the stock's value are taxed at a lower capital gains
rate. Intuition suggests that it may be financially prudent
to accelerate payment of ordinary income tax on such compensation
if the employee expects the stock's value to appreciate over
time, but McDonald shows that early exercise is almost never
optimal when the employee has paid nothing for the options
or stock grants in the first place.
mistake of accelerating tax payments to avoid future ordinary
income tax payments on a higher-priced stock is based on a
fundamental misconception that the employee has been granted
a full share of stock, writes McDonald. Actually, only a fractional
share (one minus the marginal tax rate) has been granted;
the ordinary income tax that will inevitably be deducted at
some point represents a portion of the stock's value that
the employee can never access.
tax payment — if the marginal tax rate is 40 percent
— is 40 percent of the stock position whether it is
paid today, tomorrow or several years from now. In fact, accelerating
payment of ordinary income taxes on these grants adds an additional
layer of taxation to the position: One can pay 40 percent
today and a capital gains tax rate on the growth of the remaining
position or pay 40 percent in the future without having to
pay taxes on capital appreciation.
Some of the
arguments for accelerating tax payments have arisen when borrowing
money to pay the tax has been employed as a strategy. But
McDonald argues that borrowing money to pay the tax is equivalent
to borrowing money to buy additional shares (by paying the
tax in cash, an investor avoids having to liquidate a position).
If the investor wishes to increase the share position, it
makes more sense to avoid early tax payment, but to borrow
money and buy stock. So: Why does much of the available information
on early exercise and election reinforce peoples' flawed intuition,
pushing them toward early tax payment? Arguments for early
exercise cite reasons such as "losing faith" in an employer's
prospects, diversification to mitigate risk, the penalty of
moving into a higher tax bracket for waiting to exercise options,
and locking in a low-cost basis for non-qualified options.
of these arguments are dismissed easily. If an employee has
lost faith in her firm, she might consider negotiating cash
compensation in lieu of options; better still, she could leave
her current employer for one with better prospects. Diversification
is an important goal and it may even be a rationale for early
exercise, but this move destroys value. The argument about
marginal tax brackets makes sense if one believes her income
will increase substantially in future years or if one expects
a change in the tax law.
are situations in which early exercise — or an 83(b)
election for share grants — may be justified. If you
want to buy additional shares but are restricted from doing
so, then if money can be borrowed to pay the tax, an accelerated
tax payment can be a way to effectively purchase additional
shares. Early exercise and tax payment may also be worth considering
for diversification if one cannot sell shares. Lastly, the
presence of dividends on the shares may have an effect if
one possesses restricted stock grants. McDonald proves that
early exercise is never optimal as long as the tax rate on
dividends is greater than the tax rate on capital gains.
Moses is a 2008 Kellogg School MBA candidate.