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» JenL_2 - Rande Cited in eCompanyNow

Reverse Vesting. Go Ahead, Ask for It.

By: Carolyn T. Geer

Perk-loving employees, listen up. Here’s the latest thing you can demand from your boss: options, tax-lite.

Sure, employees love stock options. Vested options are like free money, winning lottery tickets, an unexpected inheritance. Until tax time rolls around, that is. Then gains on “nonqualified” options, the most common type, can get walloped with federal income taxes as high as 39.6 percent. But as it turns out, there is a way to lessen that blow. It’s called reverse vesting, a previously little-understood technique for converting option income into long-term capital gains—for which the rate tops out at only 20 percent. “Reverse vesting’s the biggest trend you’re seeing out here,” says Jeff Saccacio, a CPA with MyCFO, a Silicon Valley-based online financial planning service for the ultra-wealthy.

We’ll get to that. But first, a little Options 101: At any point your company, whether public or still private, can grant you options, which are generally valued at an exercise price equal to the stock’s market value at the time. Then you sit and wait while the options vest over a period of years. During the vesting period, if all goes well, the stock will rise and your options will be well above the exercise price when you finally have the opportunity to exercise (i.e., buy the shares). Theoretically, you have to come up with the cash to cover the exercise price (the total cost will vary, of course, depending on how many shares you choose to buy/exercise). In practice, however, most people exercise and sell simultaneously, making this a so-called cashless exercise. Upon exercising, you’re generally liable for income tax on the difference between the stock’s current market price and your exercise price.

Here’s how reverse vesting works: The options vest and are exercised the day you get them—it’ s the actual shares that vest over time. While you wait the typical three to five years to become fully vested and able to cash out, the value of the stock appreciates not as ordinary income but as a capital gain, so you owe less to the taxman.

But caveat exerciser: Exercising early is not without risks. For one thing, stocks don’t always go up, as we’ve been so rudely reminded in recent weeks. If your company’s share price declines after you’ve exercised, you’ll be sitting on a paper loss. (Although, of course, any realized losses can be used to help offset your tax bill.) And if you’ve had to borrow any money to buy the stock, you’re still on the hook to pay back that loan (plus interest). Rande Spiegelman, senior manager in KPMG’s Northern California personal financial planning group, hasn’t heard of many situations in which an early exercise has resulted in a nasty surprise. But then again, Spiegelman cautions, it has been a roaring bull market.

So, obviously, this gambit works best at a company whose shares are dirt cheap—for example, at a pre-IPO company. But there, the danger is that you could end up paying for a stock that never comes to market. One last warning: In our example we’ve assumed that the exercise price equals the stock’s market price. But what if you’re just now discovering that you can reverse vest the options you already own? Well, if your company shares have already run up, you’ll owe ordinary income tax on the spread (the difference between the stock’s current value and your exercise price) when you exercise. Should the stock go down, or if you leave before you’re vested, too bad—you don’t get that tax money back. “The larger the spread, the greater the gamble,” says Spiegelman.

To take advantage of reverse vesting, you must make something called an 83(b) election, which lets the IRS know that you plan to take your “gains” into income immediately upon exercise. (But again, if there are no gains yet, no tax is owed.) Your company can provide an election form that you must send to your IRS office within 30 days after exercise. You must also give a copy to your company, and keep one to file with your annual tax return.

Early-exercise programs aren’t limited to nonqualified stock-option plans. Although the concept began there, it has since also found its way into the plans for “incentive” stock options. ISOs typically work this way: No tax is due when you exercise, and any subsequent appreciation is taxed at capital-gains rates if you hold the stock for at least two years from when the options were granted and one year from when you exercised. But the spread at exercise is counted as income for purposes of calculating the dreaded alternative minimum tax, a parallel tax system designed to make sure that everyone pays his fair share of taxes. With reverse vesting, since the spread at exercise is zero, your options don’t trigger the AMT.

Laurie Hall, an attorney at Palmer & Dodge in Boston, points to a client whose tech company employer recently allowed him to exercise his ISOs early so he could minimize his taxes. “It was done to be accommodating,” Hall understates. Translation? The guy is a hot commodity, and his employer wasn’t taking any chances. “In this dotcom world, there’s real competition for employees,” Hall says. Employers, you’ve been put on notice.

.....Jen

-- posted by JenL_2

» Rande - Thanks Jen.

http://www.ecompanynow.com/

For those interested in e-Commerce, B2B, etc. in particular, it's a great resource. Check this one out while you're there:

Lowdown on B2B in over 50 industries

<img src=http://www.internetcount.com/1867857677.cgif width=5 height=5>

-- posted by Rande

» lp061574 - Thanks

Thanks for your help re: how long to keep old papers. I could never go completely electronic, but I do think that if I ever have grandchildren, they will be paper free (the way we're killing trees, they may have no choice).

-Lisa

-- posted by lp061574

» lp061574 - Thanks

Thanks for your help re: how long to keep old papers. I could never go completely electronic, but I do think that if I ever have grandchildren, they will be paper free (the way we're killing trees, they may have no choice).

-Lisa

-- posted by lp061574

» Kirk - What if

We'd not have CNBC, WSW, "Jorgensen on Money", "Motley Fools" or even this web site!

Everyone would buy the index and then do other things with their time.

Question... what would determine the value of the companies?

Why I ask. Efficient market says this should work, but SOMETHING has to set the price for the stocks. Some people think growth is valuable, others value dividends or a brand name.

-- posted by Kirk

» Rande - Kirk,

The "paradox" of it all is this -- EMH advocates say all the time and money spent analying the fundamentals and past price action is a waste of time as the markets are too efficient and information is disseminated too rapidly to gain a meaningful and consistent edge over time when all the costs are factored in (including taxes). BUT, if it weren't for everyone trying the markets wouldn't be as efficient as they are. If everyone went passive, the markets would cease to be as efficient as they are and, of course, it would start all over again with individuals seeking to capitalize on information. Won't ever happen because of the nature of the business (buy/sell/hold advice generates commissions and sells newsletters, etc.), and because of human nature itself. But, interesting to contemplate that those who advocate a passive approach must acknowledge with gratitude the activities of those who continue to scramble for an edge.

<img src=http://www.internetcount.com/1867857677.cgif width=5 height=5>

-- posted by Rande

» Kirk - EMH Paradox:

Clearly some DO beat the market on a regular basis. Some Harvard dropouts in the land on no sun have done it quite well (MSFT). So did Bagley, ex AMAT CEO who left for ONTK then merged with LRCX to build another great company. Bagley invested $1M of his own in LRCX stock, a bit too early, but at about $8 a share split adjusted about 2 yrs ago (LRCC now at $40 - 5x in 2 yrs...not bad though my basis is much lower for a 10 bagger! Am I smarter than Bagley? Hardly! I just waited for a better bargain that Bagley was aware of much sooner.).

It almost all assumes a static market but we all try to outguess where the profits will be in the future as well as investor psychology.

I really liked that article you posted a link to awhile back, or did you write it up?, that showed all the "costs" in trying to beat the market. How mutual funds are actually index funds with small variances at a very high cost. Also takes into account trading costs and taxes. Perhaps you could find that article again and stick a link to it in your webpage? That seems like one worth reading on a regular basis.

What I got from it was people do beat the market, but often the costs of doing so balance out the performance gain and so they work hard to add very little value. The rest, just fail to match the market. A very few, actually outperform and I think that you need to use individual stocks... as that eliminates the "closet indexing" and "tax hits" that the mutual fund method uses.

-- posted by Kirk

» Rande - Kirk,

Right, and the KEY point to remember is that those who do manage to beat the market for a spell fail to do it on a consistent basis. Yes, there have been some exceptions such as Buffet, but even such a mighty one-in-a-billion exception as he can stumble once in awhile. In any event, the historical record is compelling and indisputable when you add up ALL the costs -- whether one is talking about trying to time the overall market or gain an edge through bottom-up stock picking, most of us mere mortals would be better off indexing. Doesn't mean we're about to give up the fight, though, does it?

<img src=http://www.internetcount.com/1867857677.cgif width=5 height=5>

-- posted by Rande

» Kirk - Ok Mr, Efficient.

HWP = HWP_W + 0.37A

Today's closing prices

HWP    $136.7500
HWP_W  $103.3750
A      $ 91.4375

Plug in the formula
$136.75 ?=? $103.375 + 0.37*$91.4375
$136.75 ?=? $103.375 + 33.8319
$136.75 ?=? $137.2069

Actually, pretty close!
The PALM > COMS market cap was much more interesting!

then again, in an efficient market, the two sides of the equation would balance. 8)

-- posted by Kirk

» Rande - If I ever get a pet monkey I'm gonna call him "Arbitrage.

<img src=http://www.internetcount.com/1867857677.cgif width=5 height=5>

-- posted by Rande