by Melissa Klein
Stock options, once as prolific as the dot-coms that doled them out like Monopoly money in the late 1990s, seemed to fall off the radar screen when the stock market bubble burst. But as the debate over expensing rages on and the economy improves, stock options are once again a hot issue.
As accounting standard-setters grapple with how to value options and the companies that issue options weigh the potential impact of mandatory expensing, financial planners say that clients are looking at options from a different perspective. The lessons learned from the bear market put things in perspective, but as the market recovers and options are back above water, will investors lose their heads? Planners don’t think so.
“Clients consider options a very valuable asset, more so now as stock prices are recovering,” said Randi K. Grant, CPA/PFS, CFP, a partner at Miami-based Berkowitz Dick Pollack & Brant. “However, I don’t think they’ll ever be what they were. I don’t think the lessons we learned with Enron and WorldCom will be forgotten quickly. No one who’s savvy is going to tie up their whole future in one place.”
“The popularity of stock options hasn’t been as important as it was before because the markets haven’t been strong,” said Grant. “It’s becoming more of an issue now. We’re seeing more companies incentivize with options, and the perceived benefit to recipients is much greater because the markets are recovering.”
“Pre-Enron, if you worked for a company, all of your money was in a company retirement plan and company stock. Your livelihood depended on your company,” Grant explained. “Now, when they’re in the money in options, people are quicker to exercise, get out and diversify. It’s a change in the mindset from an asset allocation standpoint.”
“Options are definitely less of an issue than they were in 1999, but now that the market is doing better, they’re getting more attention again,” agreed Karen Goodfriend, CPA/PFS, CFP, and principal of GoldsteinEnright Financial Advisers Inc. in San Ramon, Calif.
“In the late 1990s, when tech stocks were doing well and the market in general was doing well, there was a sort of giddiness,” said Goodfriend. “It was difficult sometimes to convince clients that there were risks and that they couldn’t expect their stocks to keep going up. Now, it’s not that hard to make that point.”
“People know what we mean now when we say it’s high risk and high potential return,” said Glenn Pape, Ernst & Young human capital leader for the West Zone. “The expectation that stock prices will climb to the sky is no longer there. Executives are still getting options, but there’s far less of a bargain element than there was four years ago.”
He added, “However, the time value element - the intangible value between the date options are exercised and the date they expire - is still substantial.”
In Bellevue, Wash., or “Microsoft country,” as he calls it, Michael Boone, CFP, of MW Boone & Associates, said that clients have “really changed their perspective” on options. “They’re much more realistic and more willing to accept advice to diversify,” said Boone. “Four years ago, we looked stupid telling people to diversify and sell some stock to pay off debt. What was reasonable, prudent financial advice looked stupid for a long time, but it’s looked pretty smart lately.”
When it comes to options, employee loyalty is still often an issue for clients, according to Stuart Kessler, CPA/PFS, partner and senior tax managing director at Goldstein Golub Kessler in New York. Many of Kessler’s corporate executive clients rely on options as a major part of their retirement.
“I’m a great advocate of diversification, but some clients feel there’s a loyalty factor,” said Kessler. “If they exercise their options, they’re worried it will be viewed as disloyalty to the company. Others feel that they have tremendous faith in their company and want to stay with it.”
Advisors noted the importance of revisiting tax planning for stock options under the tax law changes, which lowered the capital gains taxes and changed the alternative minimum tax rules.
More people have capital losses that they can realize, or have already realized, that can offset capital gains that may result from options they’ve already exercised, provided that they hold the stock for more than a year after they exercise the options, explained Goodfriend. However, she warned, the changes also mean that clients with qualified (incentive) options may be hit by the AMT more easily.
Goodfriend emphasized a strategy of diversifying and locking in the value from options. “It may not be a tax reduction strategy at all, it may be more of a risk minimization strategy,” she said. “To get capital gains, depending on the type of option, can involve taking on new risk. The tax savings can be higher, but it doesn’t offset the risk of not selling the stock. I work on discouraging people from basing their strategies on tax minimization.”
“If clients are carrying forward losses, it might be a good time to exercise options as long as they’re qualified and the client has met the holding period requirements,” said Grant, adding, “But we try not to let the tail wag the dog. We look at what’s best for the client, then we look at the tax considerations.”
“We take into account that capital gains are now down to 15 percent,” said Kessler. “If clients exercise options and hold the shares for a year and the company pays a nice dividend, say 4 percent, that’s more than you’re getting in interest today, and it’s taxed at 15 percent rather than at 35 percent.”
Increased exposure to the AMT is a major concern for Stephen Bonick, CPA/PFS, CFP, of Tax & Financial Planning Associates of Beverly Hills Inc. “If I were doing a tax projection today versus three years ago with the same variables involved, I’d probably advise clients to exercise fewer options today because of the tax bite they would probably get,” said Bonick. For non-qualified options, Bonick also considers an election that allows clients to accelerate income when options are granted so that when they’re exercised a year later, the income is taxed as capital gains. “I recommend clients make that election when the exercise price is low in relation to the current value of the stock. Start ups don’t have any value, so making that election and recognizing $1 a share in income is a no-brainer,” said Bonick.
For CPA planner Mitch Freedman, CPA/PFS, of Mitchell Freedman Accountancy Corp. in Sherman Oaks, Calif., stock options have become “a non-issue.”
“In my practice, options went away completely,” said Freedman, who has clients in the entertainment field, young entrepreneurs and executives of large companies. “The clients who have options are underwater, and it’s not a planning issue.”
While the question of whether expensing will become mandatory and how options will be valued if it does is far from resolved, many advisors said that expensing could impact clients with significant options to some degree, as well as the companies that issue them.
“I think the heyday for rewarding employees with options has passed,” Freedman said. “With the trend toward expensing, it’s no longer as valuable to the employer to do it, because it will cost them earnings and the earnings decline will have a negative impact on the ability of options to be in the black.”
“From what I’ve seen, a number of companies are starting to look toward other ways to provide value to employees,” said Freedman. “There will always be companies who will use options to reward and retain employees, but more are going back to cash and deferred types of accounts because options haven’t given value to employees and employees haven’t perceived value from them.”
Boone noted that Microsoft, which could be a bellwether for large technology companies, has stopped issuing options and started issuing stock and paying small dividends.
“Expensing could have a negative impact on stock option plans as far as whether some companies continue them,” said Grant. “Some companies may amend their plans so they don’t have a dilution in earnings.”
“Conventional wisdom says that if companies expense options, it will have a chilling effect on the amount of options they issue and that it may strengthen the movement for share ownership guidelines, or an interest in developing options that are more aligned with the incremental improvement the company has generated in the market place, which would reduce the value of options for many executives,” said Pape.
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