The Married Put [1]

Employee Stock Option [ESO] Planning for 2018/19                        

                          ESO Risk v. Reward

              Risk                                             Reward  

   Exercise-Hold <<<<<<< >>>>>>> Exercise-Sell

A conundrum an employee may face in the management of their employer common stock [ECS] equity assets is a classic risk-reward situation. Sell ECS and/or exercise and sell ESOs now, i.e., mid-April 2018, in the face of a potentially flat or down market over the next year, foregoing risk but also additional ECS appreciation. That is where the MP could be of some utility.

Financial instrumentation has come a long way since 1973, the first year of trading in listed, exchange-traded options [LETOs], i.e., puts and calls, on the Chicago Board of Options Exchange. The purchase of a put is the purchase of a right to sell the stock underlying the contract. The MP is created in conjunction with the exercise of an ESO, where ECS is delivered into brokerage accounts on the same day that the put is purchased, i.e., “married.” It would be helpful, although not required, that the put exercise price be roughly equal to the fair market value [FMV] of the ECS on the day of ESO exercise, i.e., it would be at-the-money [ATM]. The MP, and an alternative idea, may provide extraordinary utility in the current investment climate. 

As we move into May of 2018, a purchase of an ATM put that has a contract termination that extends into 2019 and a life longer than one year, i.e., beyond April of 2019, might make the most sense, as the achievement of long-term capital gains is important. For the purposes of this article then, we have an ATM put purchased upon ESO exercise that has a life longer than one year and whose contract expires after April of 2019, stipulated as “ESO_ATM_Put>4/2019”. As the MP utility is available also for employees holding incentive stock options [ISOs], this article also presents an ISO planning idea that does not involve the MP strategy.

The ISO Planning Dilemma

The employee holding ISOs runs a tax gauntlet. ISO bargain element [2] is a prime driver of the alternative minimum tax [AMT] where such tax is greater than your regular tax liability. Separately, we also have the new net investment income tax [NIIT] which results in a new excise tax of 3.8% on modified adjusted gross income [MAGI] as well as an added 0.9% tax for Medicare. An IRS compliance target is unprepared taxpayers involved in complex tax situations. 

This then should be considered by all parties a combined transaction [CT], the administration of which falls under the auspices not only of the employer administering the employer’s various stock plans via specialized software, e.g., E*TRADE’s EquityEdge, but also of the broker-dealer effecting the trades of the LETOs. This CT should be annotated as such, preferably on the order ticket in which the LETO put is purchased, cross-referencing the ISO exercise which is similarly annotated with the description of the put purchase. Remember, as long as the two instruments are in a CT, risk transference as stated above is assured. 

For the price of the put, the employee has completely transferred any risk [downside] inherent in the ownership of ECS covered by the put for over one year, which is important as we have to hold ISO-acquired stock for at least one year. The tax, i.e., cost, basis of the CT is now the exercise price of the ISO to which is added the cost of the put. As ISO-acquired stock is a dual-basis asset, i.e., it has a basis for the AMT also, that equals the FMV of the stock on the date of exercise plus the put cost. The CT may have a variety of planning outcomes that deviate from the complete risk transference, based upon an unbundling of this CT and your belief that you are somehow smarter than the market. We do not advocate such “unbundling” but there is a planning path that might be helpful in lieu of the use of the MP.

Investment Planning

An example might be helpful. In late April 2018 the market “condition” has been altered somewhat as there now appears to be an enhanced probability of an outcome other than “up” going forward. Let’s assume that as an employee of the XYZ Corporation you have exercised 1,000 XYZ ISOs in January of 2018 before the sell-off, when the stock was at $100 and your XYZ ISO exercise price was $50 per share. You now have $50,000 of AMT positive adjustment for your 2018 tax return, i.e., Form 6251, and a holding period for your ISO that extends into 2019. You also have a dual-basis asset in the ISO-acquired stock that currently, has a basis of $50 for regular tax purposes…and $100 for AMT purposes. Some confusion hear but not beyond the reach of anyone receiving ISOs.

With $50,000 of positive AMT adjustment, you may trigger the AMT for 2018, paying more than your regular tax liability. A stock sale in 2019, could also trigger the NIIT and the added Medicare tax with the gain from the sale of XYZ stock if you are above the threshold amount of $250,000, i.e., married filing jointly. That confusion is now starting to cost the average employee some money!

The conundrum faced by the taxpayer benefits the IRS, i.e., do I get involved with all this planning nonsense or just do nothing and hope for the best? What follows then are planning variants that revolve around the acronym…C.A.S.H. or:..

Certainty...AMT Planning...Stock-basis Planning...Higher-bracket Planning

The use of cashless option exercise [COE] [3] ends the discussion about risk with a cash windfall, creating certainty, but the ISO exercise [and hold] creates an AMT planning requirement that requires basis planning for a dual-basis asset. Along the way, in both 2018 and 2019, there could be an issue with regular tax planning surrounding the addition of more regular income and a higher tax bracket. Experience suggests that this IRS compliance target includes employees holding both NSOs and ISOs in a salary range between $150,000 and $250,000 and in a situation like our XYZ sample employee above, that the amount of unnecessary added taxes would be in the $3,000 to $7,000 range. Time for the alternative planning idea!

ECS Market DOWN Before Year-End

Our XYZ employee exercised 1,000 XYZ ISOs at $50 with the ECS at $100 and “baked” in an additional $50,000 of AMT adjustment into his/her tax calculation “cake” for 2018. XYZ continues to decline and by the beginning of December 2018, the stock is at $40 per share. Now the investment decision about XYZ is colored by the employee’s tax situation. Will funds be available to meet the tax liability created at the higher XYZ price upon ISO exercise? This is not a new issue or problem as it occurred with some regularity in the dot.com bubble some eighteen or so years ago. The employee may have an “out” presented to him by Internal Revenue Code (“IRC”) Section §422(c)(2) [4] [see https://www.law.cornell.edu/uscode/text/26/422].

This IRC Section allows the employee to disqualify the shares acquired through ISO exercise, converting the ISO into a nonqualified stock option (“NSO”). The ordinary income generated from the now converted NSO exercise is the lesser of the FMV at exercise or the FMV at the sale of the stock creating the disqualifying disposition. In this case, the employee would now have $30 worth of ordinary income [$40 current FMV - $10 ISO exercise price] and his or her AMT liability would go away. The employee could easily calculate the added regular tax liability and decide whether and how many of the original 1,000 shares could be disqualified. 

One should remember that this can only be done in the same calendar year as the ISO exercise, lest the taxpayer employee compound the situation by effecting the disqualifying disposition in 2019, where the AMT adjustment for tax year 2018 has already been established. From a housekeeping standpoint, one should remember that all advisors and the employer should be mindful of what has occurred and adjust their records, i.e., database, and reporting accordingly. In other words, everyone should be on the same planning page. Finally, one should be aware of any wash sale considerations under IRC §1091.[5]

Summary

There will be a tradeoff with the above between planning expense versus benefits perceived and achieved. In some cases, the need for certainty may override the planning costs. What is important is the realization for the employee that such planning is available and that their planning platform, i.e., their employer’s as well as their advisors’ capabilities, will support the effort.   

Issues as the ones discussed in this article have largely gone unnoticed over the better part of the last decade. The IRS however has noticed and is very much looking forward to picking up a lot of badly needed “loose change” over the next few years. Let’s try to keep them on a short leash!

[1] The following MP discussion pertains to non-insiders of publicly-traded companies [PTCs] exclusively. Although the utility is also available to corporate insiders, it should only be approached in an engagement setting that involves all disparate parties in the process so as to ensure complete “buy-in”. 

[2] The bargain element of any option is the difference, at a point in time, between the current fair market value of the stock underlying the option contract, and the contract exercise price itself.

[3] COE of an ISO is an immediate disqualifying disposition of same by the sale of the stock acquired, resulting in non-qualified stock option [NSO] tax treatment.

[4] (2) Certain disqualifying dispositions where amount realized is less than value at exercise If—

(A) an individual who has acquired a share of stock by the exercise of an incentive stock option makes a disposition of such share within either of the periods described in subsection (a)(1), and

(B) such disposition is a sale or exchange with respect to which a loss (if sustained) would be recognized to such individual, then the amount which is includible in the gross income of such individual, and the amount which is deductible from the income of his employer corporation, as compensation attributable to the exercise of such option shall not exceed the excess (if any) of the amount realized on such sale or exchange over the adjusted basis of such share.

[5] The wash-sale rule disallows a loss taken where similar securities are purchased within 30 days on either side of that loss from a calendar standpoint.