An ever-increasing number of companies are granting stock options to employees or executives in lieu of direct compensation for services, bonuses, etc. This is particularly true in the case of many .com and Internet startup companies. Essentially, the person who receives the grant of a stock option has the right to buy a certain number of shares at a fixed price. The option agreement sets forth the terms and conditions for exercise, vesting and may or may not impose other restrictions on the recipient. It is important to note that the granting of a stock option carries absolutely no guarantee of value now or in the future from the issuing corporation. Therefore, careful consideration should be given by the employee to the current financial condition and future prospects for growth of any potential employer offering stock options in lieu of monetary compensation.

There are two basic types of stock option plans. The taxability of a stock option plan depends on whether the plan is a "qualified incentive", or a "non statutory" stock option plan. A qualified incentive stock option plan is generally available to employees only. These types of plans are covered under Internal Revenue Code paragraph 421(a). In contrast to non statutory option plans there is no taxable transaction when the option is first granted, and generally no taxable transaction when the options are actually exercised. A word of caution: it is important to note that the difference between the option price and the fair market value at the time of exercise, (also known as the bargain element) is a preference item for the alternative minimum tax calculation unless the stock is sold in the same year. In order to enjoy the more favorable capital gains tax treatment, certain holding requirements need to be met. In general, the stock must be held for at least two years from the date the option was granted and at least one year from the date the option was exercised. A sale prior to the end of the holding period will shift the amount of the bargain element to ordinary income.

Non statutory stock options are slightly more complicated from a tax perspective and generally, the proceeds are taxed as ordinary income effective the date of exercise. For non statutory stock options, the amount of income to include and a time to include it depends on whether the fair market value of the option can be readily determined at the time the option is granted. Now, if the fair market value of the option cannot be readily determined, the option is taxed at the time it is exercised by the employees. The amount the employee is required to include as ordinary income is, the difference between the amount paid for the stock at its fair market value at the time the employees had an unconditional right to receive it. The employee's basis in the stock equals the amount paid, plus the amount included in income at the time the option is exercised.

Upon exercise, employees are faced with a number of perplexing income, estate tax and financial planning issues. One overriding issue, however , is what to do when the stock of one company constitutes the bulk of their net worth. As an employee of the firm granting the options, they are probably in a better position than most to judge whether this company will be successful in the long term. And, of course, there can be no guarantee that alternative investments will do any better. There are, fortunately, a number of techniques and strategies available that address problems associated with a concentration of a single stock in a portfolio. Options based strategies such as charitable remainder trusts provide diversification without current taxation. There are, of course, other strategies that can be employed which are beyond the scope of this short discussion, please contact us for details.

Always remember though, past success is no guarantee for the future. A recent Sanford Bernstein study indicated that of the 10 most admired companies in America as rated by Fortune magazine in 1988, only Merck made the list just 10 short years later. So what were the 10 most admired companies in America in 1998?

1. Merck
2. Rubbermaid
3. Dow Jones
4. Proctor and gamble
5. Liz Claiborne
6. 3 M
7. Philip Morris
8. J. P. Morgan
9. R. J. R. Nabisco
10. Wal-Mart

In 1998, Merck had drifted to 10th place with all the other companies dropping out of the race. They're also been some extreme cases were a betting on a single stock can lead to a fiscal disaster. Examples of these include Ames Department Stores, whose cumulative returns from 1982 to 84 were 298.6%. However, between 1985 and 1998 their cumulative returns were -100%. Other giant disasters include Zenith Electronics, Pan Am and Wang laboratories.

To illustrate the point that sustained fast growth is rare, Sanford Bernstein studied 34 technology stocks beginning in 1980. The results were startling. From 1980 through 1999, 22 of the 34 had stopped trading, 11 were still trading, but, all have trailed the S&P 500*. Three stocks lost over half their value and of the 34, the only big winner was Intel.

Unfortunately, the taxpayer relief Act of 1997 effectively eliminated two popular approaches to limiting and diversifying risk; "Shorting against the box" and "Equity swaps". After T R A 1997, other options based hedging strategies have become increasingly popular. Techniques such as charitable remainder trust are still available, albeit with new restrictions.

So what are the decisions that need to be made when exercising options?:

A CFP® Certificant or qualified tax professional can assist you in establishing the type of plan you have been granted, the size of the gain upon sale, your marginal tax bracket , the percentage of your net worth represented by the single stock , as well as your investment horizon , tolerance for risk , and the projected volatility of the stock in question . He or she will then be able to advise you as to whether, and how much, of the stock should be held and how to reduce volatility while creating diversification in your portfolio . A CFP® Certificant will also be able to assist you in reducing the risk of loss through utilization of other, more advanced strategies. In conclusion, comprehensive retirement and estate planning may become necessary depending upon the size of your estate after the options have been granted.

* The S&P 500 is an unmanaged stock index. S&P 500 is a registered trademark of Standard & Poor's Corp. Investors cannot invest directly in the S&P 500 and past performance is not indicative of future results.

If you are resident of Southern California, have received stock options from your employer and are in need of assistance, please contact me at:1-800-444-2237. I would be happy to assist you in solving the complex issues surrounding stock-option plans and making the right decisions for your future. You can also contact me via e-mail by clicking on the button below.

Nigel B. Taylor, CFP¨ is a Registered Representative of and offers securities products & services through Royal Alliance Associates, Inc. Member FINRA/SIPC, a registered Broker-Dealer. In this regard, this communication is strictly intended for individuals residing in the states of California and Nevada. No offers may be made or accepted from any resident outside the specific state(s) referenced. Separately, Taylor & Associates is a CA Registered Investment Adviser

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