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Exercising options

Should you accelerate income tax payment on share-based compensation?

Based on the research of Professor Robert McDonald

By Joshua Moses '08

  Robert McDonald
  Robert McDonald  Photo © Evanston Photographic

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The 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?"

When 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.

The 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.

The 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.

Some 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.

There 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.

Joshua Moses is a 2008 Kellogg School MBA candidate.

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