Advisors must contend with potentially complex tax and retirement issues.

Four years ago, Beth V. Walker became frustrated when she sought advice about her husband's employee stock options from tax and investment professionals. "His company gave us the obligatory forms and explanations, but we still had questions about alternative minimum tax implications, IPO blackout periods and other issues," says Walker, a financial advisor with The Wealth Management Group in Las Vegas. "I got conflicting advice, and much of it turned out to be incorrect. It seemed like no one could point me in the right direction."

Walker decided to capitalize on her frustration by learning about stock options so that she could use her specialty to advise clients and build business. She joined the National Association of Stock Plan Professionals to learn more about employee stock options and other forms of equity compensation. She ran stock option seminars for employees at public companies in the area.

Two years ago, she wrote a book on the topic called An Employee's Guide To Stock Options (McGraw-Hill). Today, she specializes in stock options planning, an area that she believes remains vastly underserved. "The Las Vegas area is home to 23 gaming companies and 42 other public companies," she says. "It's a very good market for what I do, and I have almost no competition."

Financial advisors considering boning up on employee stock options, either to build new business or to serve current clients more effectively, do so at a time when these instruments are making a comeback. Over the last decade, the perception of stock options has changed from an obscure perk for upper management at technology companies, to a path to quick wealth for bull-market wave riders, to underwater fodder for dashed dreams. After last year's bull market, some of those dreams became resurrected as option holdings vaulted back into profitable territory.

To be sure, options are not the hot ticket they were in the late 1990s, when overnight "optionaires" cashed in at triple or better the exercise price. Financial Accounting Standards Board proposals to change the way companies handle option expensing could curtail their use, to some extent. A bearish or sideways market would jeopardize profitability, or increase the time it takes to reach that goal.

Still, employee stock options will likely remain a popular way for companies to attract and motivate executives and workers. At the same time, they will continue to create opportunities for financial advisors willing to put in the time and effort needed to learn about them. Individuals with vested, in-the-money options-including those with options granted in the mid-1990s that are approaching their ten-year expiration dates, as well as those holding options granted during the recent bear market-have to decide whether this is a good time to take their money off the table, or to hang on and wait for their employer's stock to climb higher. Contrary to popular perception, techno geeks at start-up companies aren't the only ones facing the decision. According to the National Center for Employee Ownership, 14.6 million individuals representing 14.4% of employees at for-profit companies have been awarded stock options. More than 41% of employees earning at least $75,000 a year at companies that offer stock options own them. While employees in the technology sector are the most likely to own stock options, they can be found in just about any industry.

Yet many employees have only a vague idea of how their options work, or even whether or not they have them. According to a recent survey from Fidelity Investments, nearly 1 million U.S. households let options expire from late 1999 through late 2000, a period spanning both bull and bear markets. More than half of stock option plan participants let their options expire not because of market conditions, but because they simply did not understand such plan specifics as how to exercise.

The study also shows that many option holders who exercise let outside circumstances, rather than careful forethought and planning, drive the decision. Of those who exercised, 22% said they did so because they needed the money while another 21% pulled the trigger because their options were set to expire.

This casual attitude toward options can make it difficult to effectively integrate them into a financial plan. "Many advisors don't find out that someone has stock options because clients view them as a perk or a benefit, rather than as compensation," says Walker. "You may need to do some digging and ask questions to get the right answers."

Walker finds that even upper-level managers can be surprisingly clueless. "I had the CFO of a major gaming company tell me he had no idea what kind of stock options he had," she says. "Another senior executive ran into my office three days before his options were set to expire and asked what he should do."

Such whirlwind options planning is not unusual, says Bill Dillhoefer, director of business development for Net Worth Strategies, a firm that offers stock option software and consulting services for financial advisors. "Typically, an advisor will initially contact us when a client walks in the door, dumps some plan documents in his lap, and asks him to analyze his options portfolio and develop an exercise strategy," he says.

The Exercise Decision

Dillhoefer says that giving the standard rule-of-thumb advice to cut, run and diversify if options are well in the money grossly oversimplifies the decision-making process. "Stock options are unique investments with complicated tax features. Advising someone to exercise all of their options at once can be a bad move, because in many cases it makes more sense to exercise over a period of several years," he argues.

Holding stock options as long as possible often makes sense because they are an inexpensive, tax-efficient way to participate in the price movement of a stock, notes Michael Beriss, a senior financial advisor with American Express Financial Advisors in Bethesda, Md. And the longer they have until expiration, the more time value they have. "Nonqualified options have the greatest value if they are held unexercised for as long as possible," Beriss says. "That's why professional options traders usually exercise on the last possible day. They are also a great form of leverage. If the stock goes down, you haven't lost anything, and you haven't paid any interest charges."

At the same time, Beriss acknowledges that holding on to options for extended periods of time may conflict with a planner's diversification standards. "Deciding whether or not to exercise for diversification is a judgment call that has to be made by the client and the financial advisor," he says.

Therein lies the rub of options planning. While advising someone to exercise all their options and invest the profit in a diversified portfolio may seem like the right thing to do-and bring in more management fees or commissions almost immediately-options specialists say it is not always the best move from a tax or financial planning standpoint. But their experience shows that giving knowledgeable, well-thought-out advice has the potential for reward down the road, when clients eventually exercise their stock options and invest the profits.

Deciding when to exercise is probably the most critical decision option holders face. Michael Fitzhugh, a financial advisor and certified public accountant with Kochis Fitz in San Francisco, says recommending an exercise if stock tied up with an employer exceeds a certain percentage threshold is a common, yet oversimplified, approach.

"We look at the financial goal first," he says. "If someone has a lot of wealth in the form of stock options, and already has enough money set aside to meet financial goals, he may not need to exercise if he has faith in the stock and the company's future. On the other hand, if exercising someone's options is the bird-in-the hand that will make reaching financial goals a reality, it makes more sense to take the money off the table right away. The key question is whether or not someone would have a real problem if their options peter out."

Fitzhugh says that determining whether someone has too much money tied up in company stock or stock options is not an exact science. "An employee with another 20 years until retirement is in a better position to take the risk of a concentrated position than a 60-year old who is about to retire," he says.

He emphasizes that any opinion about how a company's stock will perform must come from the client. "We never take a point of view about whether or not a stock is going to go up, down or sideways," he says. "We have no insight about a company's prospects, and we make that clear from the beginning. That's not what the client is paying us for."

Beriss generally recommends that clients have no more than 10% to 25 % of their investments tied up in company stock, unless they have already met their core portfolio goals. "The question you need to ask is if the stock went down to zero, would the client still be able to retire as scheduled," he says. He also tries to quantify the risk of a concentrated position in stark terms. "Someone who owns 100,000 shares through stock options needs to be aware that every time the stock moves $1, his net worth increases or decreases by $100,000."

Beriss says that despite the recent bear market that left many option holders with deflated investments and huge tax bills, overconfidence in a company and its stock remains an obstacle to diversification. But, he adds, "clients seem to be more open to moving in that direction than they used to be."

Any options planning must also take into account tax considerations. Tax treatment at various points in the options life cycle will depend on the kind of stock options someone has. You can usually find this information in plan documents.

With nonqualified stock options, taxes usually bite into profits at two points. When the owner exercises the option, the difference between the market value and the lower strike price is treated as compensation income on that year's tax return. Once the stock is sold, the cost basis for tax purposes is the market price on the day the option is exercised. Gains on stock held for more than one year after the exercise date are taxable at long-term capital gains rates. The major tax glitch with nonqualified stock options is that many companies withhold at the statutory rate of 25% at exercise, even if someone is in a higher tax federal bracket. Clients who have not had enough withheld from their options check face a large, unexpected tax bill down the road.

Incentive stock options (ISOs) work differently. At exercise, the difference between the market value and the strike price is generally not taxable. When the stock is sold, the tax is based on the difference between the strike price and the price at the time of the sale. This amount is eligible for favorable long-term capital gains tax treatment if the shares are held for more than a year, and if the sale occurs more than two years after the option grant date. Because it is possible for the entire profit on ISOs to receive favorable tax treatment, they are usually considered more desirable than nonqualified stock options.

However, ISO owners face the alternative minimum tax. Although regular income taxes are not due at exercise, as they are with nonqualified options, the difference between the strike price and the exercise price is treated as income for the purpose of calculating the alternative minimum tax. Depending on individual circumstances, and with the help of a tax professional familiar with options planning, it may be possible to take some of the bite out of the AMT.

Stock Option Resources

Fairmark Press (www.fairmark.com). Tax attorney and author Kaye Thomas offers easy-to-digest explanations about how employee stock options work and outlines the tax implications associated with them. Thomas also founded the National Board of Certified Option Advisors (www.nbcoa.com), a new options certification program for financial advisors.

National Center For Employee Ownership (www.nceo.org). The Web site of this 23-year-old non-profit organization contains useful articles about stock options, stock purchase plans, ESOPs and other equity-based compensation.

MyStockOptions (www.mystockoptions.com). The site has free option calculators as well as articles by financial advisors, tax attorneys and other professionals specializing in stock options.

Net Worth Strategies (www.networthstrategies.com). Offers stock option consultation services and software for financial advisors.