I was sitting down with a client who was considering exercising an incentive stock option. The option had been granted to him from his employer to purchase 2,000 shares of his employer’s stock at a purchase price of $25 a share. This was rather intriguing to him because the stock was recently trading at $50 a share, doubling his potential investment. The only problem was that he was concerned about coming up with $50,000 cash to purchase the company stock—he currently had three children in college and had purchased a new boat, so cash seemed to be sparse in his household at the moment.
After reviewing his situation, I suggested he complete a stock swap to purchase the new shares. Basically, this meant he would use old shares of company stock he’d been hanging on to from a previous exercise of an incentive stock option and swap them for the new shares. A stock swap might not always be the best solution for every stock option-holder, but in some cases, it is a perfect fit. The process of completing a stock swap is complicated and intricate, and it is best performed with the help of an executive financial advisor who understands the ins and outs of this type of exchange, as well as the potential taxable outcomes.
To better understand how an incentive stock options swap works, and if it might be a good strategy for you, here’s a closer look at this method and the considerations to make before moving forward with this strategy.
How Does an Incentive Stock Options Swap Work?
Stock swaps are not a new concept, but if you haven’t exercised employee stock options recently, they may be foreign to you. It’s important to consult with an experienced executive financial advisor prior to performing a stock swap to ensure that the swap is advantageous for you in all aspects. To explain how a stock swap of incentive stock options works, let’s continue with the example of my client from earlier.
My client was essentially able to “swap” the old stock, for which he had a low cost basis, for the new stock, for which he had a higher cost basis. One of the major benefits of doing this was that he didn’t need to come up with cash to purchase the new stock because he swapped it with old employee stock he was holding on to. This was a tremendous benefit because he had no out-of-pocket expense, and he was able to avoid taxable gain for regular tax purposes since he held his old stock for more than two years.
Here’s a breakdown of this client’s stock swap:
- The client used his old stock with a current value of $50 per share, of which he owned 1,000 shares, and swapped it to purchase the new stock.
- The value of the old shares was $50,000 on the current market, which completely covered his cost of the new grant price of $50,000.
- This gave him 2,000 new shares of company stock, without paying any money out-of-pocket.
- There was no taxable incident since he had held his old stock for more than two years, and he doesn’t plan to sell his newly acquired stock anytime soon.
- There could be possible alternative minimum tax implications with the stock swap, but that is dependant on income levels and other factors, best discussed with a CPA or tax professional of choice. (The alternative minimum tax applies to taxpayers with a high income by setting a limit on tax breaks and tax-deductible benefits. This ensures that taxpayers pay a minimum amount of tax.)
This turned out to be a great strategy for this particular client because it addressed his desire to purchase new company stock as well as his lack of cash on hand to do so.
What to Consider Before Swapping Your Incentive Stock Options
Of course, there are quite a few considerations to make before engaging in a stock swap to purchase new company shares through an employee stock option program. This is where working with an experienced executive financial advisor can be helpful because they can walk you through the questions to ask before making a decision.
Some of those specific questions and considerations to make include:
- Do you have enough cash on hand to purchase the new company stock? If you have enough cash on hand to purchase the shares outright, it might make sense for you to do that rather than utilizing a stock swap. It will depend on your financial situation, but in some cases, a cash purchase can be more simply executed than a stock swap.
- Do you have faith in the financial solvency of the company moving forward? If you are unsure of the financial future of your employer, you may want to hold off on purchasing more shares of company stock, as this will increase your concentrated position.
- Have you considered how exercising your stock options will affect your tax bill? In certain situations, exercising your incentive stock options can increase your income taxation and possibly trigger an alternative minimum tax liability. This is definitely something to consider before exercising any options.
- How concentrated is your current stock position? Many top-level executives hold a significant portion of their overall net worth in company stock. Purchasing additional company shares through a stock swap may further concentrate your stock position. Depending on your financial situation and goals, a higher stock concentration could increase the overall risk in your investment portfolio.
At the end of the day, when considering whether or not to utilize an incentive stock options swap, you should factor in your own personal financial situation coupled with the upside opportunity in purchasing more company shares. The best way to factor in all of these different aspects is to work with an expert in equity compensation plans for top-level executives. A trusted wealth advisor that meets that criterion will prove quite valuable in your decision-making process.
K. Wade Carpenter, CFP®, AIF®, ChFC®, CLU®, is an innovative wealth manager serving corporate executives and entrepreneurs from coast to coast. Throughout his more than 25-year career, Wade’s focus on C-level clients has made him a top strategist for equity compensation planning for executives. For more information on how Wade and the Carpenter Team can advise you on doing an incentive stock options swap, reach out today for a complimentary consultation.
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