Timing is everything for realizing gains and avoiding tax liabilities.

    Like reaching for the brass ring, stock options have traditionally offered a challenging opportunity to give a considerably better-than-nice boost to executives' portfolios. For financial advisors and clients alike, the big questions have always been when and how to exercise options.
    There are scores of variables to consider. Much depends, for example, on what percentage the holding is of the client's total portfolio, as well as how close he or she is to the expiration of the option. There's also the challenging question of how the underlying stock may do down the line.
    Other considerations include the client's basic objectives in exercising the option, how close he or she is to retirement and tax issues.
    The task can be daunting since stock options are a moving target. On the one hand, companies are issuing fewer of them in the wake of the Financial Accounting Standards Board's recent decision to require companies to expense options on their financial statements beginning June 15. On the other hand, stock options could get a new lift from proposed tax code changes by the Bush administration.
    Given the fluid situation, just what approaches and actions should you recommend for clients when they have the opportunity to exercise a stock option?
    Four advisors active in this area weighed in with their respective strategies and advice: Christopher J. Cordaro, a partner and chief investment officer at RegentAtlantic Capital LLC, a wealth management firm in Chatham, N.J.; Tim Kochis, a certified financial planner and CEO of Kochis Fitz, a wealth management firm in San Francisco; Eleanor Blayney, managing director of Sullivan Bruyette, Speros & Blayney, a part of Harris Private Bank in Chicago; and Mike Busch, president of Vogel Financial Advisors in Dallas and chairman of the Dallas-Fort Worth Planning Association.
    In setting up a strategy, Busch first develops a plan with clients on how to exercise their options over a period of time. He believes they should stagger the exercise dates and subsequent sales over several years to spread out taxes. "Committing to a plan to exercise options at a particular price point helps individuals follow through instead of getting caught up in the momentum of price swings," he says. "Committing to an exercise schedule usually helps the client pull the trigger on the exercise, instead of delaying in hopes of continual market appreciation."
    Blayney says she first asks clients where they think their company's stock price is headed. If they think it's going down, she advises to exercise a significant number of shares. "Following that same logic, if they think the price is going up, then you actually should put off exercising as long as prudently possible" to take advantage of leveraging.
    Kochis, whose clients are primarily executives and whose firm has an analytical format and an interactive online version posted on its Web site, www.kochisfitz.com, says clients face two fundamental alternatives at exercise time: They can either exercise to sell the stock or exercise to hold it. If they elect to sell it, it's usually either to diversify their holdings and invest in something else or to gain access to the money to spend it.
    If the objective is to spend, "the logic then," says Kochis, "is you wait until there is an appropriate trigger, which is when the stock option spread-what you would capture by selling the stock as soon as you've exercised-buys you something you want."
    The alternative reason for exercising an option is "to hold the stock for the long term, either because you think it's a superior investment or because you're required to hold it."
    In this case, barring an exception, Kochis advises clients to wait to exercise an option until just before it expires. "You don't want to put your money down any sooner than you have to," he says. "The day before it expires is when you want to exercise if your plan is to hold the stock. Whatever the stock is going to do over the long term, you're going to be able to capture by exercising it at the very end. In general, there's no point in going in early, but there are numerous exceptions." Advisors like Kochis focus quite a bit of attention on those exceptions.
    How close a client is to retirement can be a deciding factor in exercising a stock option. "If the horizon is ten years or more, you might be able to take more risk; if you're within a few years of retirement, you want to make sure you have that critical amount of capital," says Cordaro, whose clients are primarily corporate executives.
    "In essence," says Blayney, "the retirement date forces the expiration date. You want to begin to exercise options with sufficient time before expiration or retirement so that you can diversify the exit price."
    As an example, say someone has an option set to expire June 30. "If they wait until June 29, and that's the date the bottom falls out of that stock, they may end up with no value whatsoever," says Blayney. "It's a risk you don't need to take. You don't want to depend on a given price on a given day to realize that value. That's why you want to use the beneficial effects of leverage. The longer you wait to exercise with a stock that is appreciating the greater or more beneficial the effect of leverage. But you don't want to wait so long that you're exercising all your options the day before expiration. We tell our clients about 18 months to two years before expiration is time to think about an orderly divesting strategy."
    Other considerations relate to risk or seeing to it that the client is diversified. "The point is," says Cordaro, "does your whole life depend on the value of these stock options? If it does, then you're taking on a lot more risk. If you're not depending on it, it's a different story; but you're still at some risk."
    It's not unusual to find employees with more than 50% of their net worth in their company's stock, says Busch. "For example, if a client owns a stock option with an $80 strike price and a $100 fair market value, it only takes a 20% drop in a stock price to wipe out 100% of his stock value," Busch notes. "A lot of people completely miss that concept."
    To illustrate to clients the irrationality of being too concentrated in one stock, Busch asks them what they would think of him as an advisor if they asked him to develop a portfolio from scratch and he advised putting 50% of their assets in one company. "At that point," says Busch, "they should recognize malpractice and I'd expect them to go looking for another advisor. Yet that's exactly how they're advising themselves."
    In any planning, advisors obviously need to factor in the tax ramifications. Exercising some or all of the stock options could possibly trigger the federal alternative minimum tax, or AMT.
    "Taxpayers in the high-income and real-estate taxing jurisdictions are the ones most at risk because income taxes and real estate taxes are not allowed as a deduction in calculating the AMT. They're added back," notes Michael R. Steiner, CFP, CPA, and wealth manager at RegentAtlantic Capital.
    Moreover, the AMT is only triggered by exercising incentive stock options (ISOs). Nonqualified stock options (NQs) don't create AMT issues because NQs are fully taxed at the time they're exercised. For an ISO, the difference between the exercise price and fair market value at the date of exercise is a preference item in the calculation of the AMT tax.
    When it was launched in 1969, the AMT was designed to keep high-income earners from using options and other sophisticated strategies to escape paying tax. Since then, stock options have become much more widespread as a form of compensation, and with the dot-com era of the 1990s, much more valuable. As a result, a growing number of taxpayers are vulnerable to the AMT.
    Indeed, by 2010 the U.S. Government Accountability Office, or GAO (formerly the General Accounting Office), estimates that as many as 17 million to 30 million people will be affected by the AMT, or roughly 16% to 30% of all taxable returns. President Bush's proposals for altering the tax code include a possible change in this provision.
    What advice can advisors give clients under these circumstances? "When somebody gets into a situation with an incentive stock option, quite often the tax advisor isn't consulted first and therefore the AMT is really an unfortunate surprise at tax time," says Maggie Doedtman, advice manager of H&R Block in Kansas City, Mo.
    She recommends that the tax advisor and financial advisor work in concert to overcome the AMT burden. "When the tax advisor can estimate exactly how much regular tax versus AMT a client will owe, the financial advisor can then recommend how many shares the client can exercise without going over the AMT mark. You don't have to exercise every single share at one time."
    Given the burst bubble and post-Enron scandals, as well as the FASB ruling, stock options will certainly not be as popular going forward as they once were. Companies are exploring other forms of incentive compensation, such as more cash, bonuses and restricted stock. H&R Block, for one, says it has added the restricted-share component to its incentive compensation plan.
    Blayney believes many companies are moving away from stock options because of the perception that "there could be mismanagement when too much is paid out in the form of stock options. Stock options can motivate companies to manage their stock price and not their core businesses. That's not good. So I think a lot of companies are doing the right thing and putting less emphasis on stock options.
    "They're moving up salary. Microsoft is a good example. They've radically cut their option program and are compensating people with higher base salaries. If a client has negotiating power to specify their compensation package, we recommend that they get paid adequately with cash benefits and not rely entirely on stock options."
    Whatever form of compensation is used, "The public, press, politicians, shareholders and analysts will find plenty of things to complain about," says Kochis. "The genius of stock options is that an executive only makes money if the stock price goes up, whereas with cash or restricted stock, the executive can still take home substantial wealth even if the stock price goes down."
    Advisors like Busch, however, warn that moves toward other compensation like restricted stock can be a double-edged sword. On the one hand, employees "receive something that's guaranteed to have value unless the company goes bankrupt," he says. "But they're losing a lot of upside potential they had with stock options."
    As you do in planning any strategy for clients, when considering how to exercise stock options you must make sure that you've covered all the bases. Realize it's not a matter of one-size-fits-all-each client's situation will be different.
    It doesn't look like stock options will go the way of the dodo bird just yet.

Bruce W. Fraser is a freelance financial writer based in New York City. He has contributed to Individual Investor, Mutual Funds Magazine, CNBC.com, Forbes.com, and Worth.com, along with many other publications. He can be reached at [email protected].