Hedging Appreciated Employee Stock Options: Tax, Economic, And Regulatory Concerns
By Robert Gordon and Mark Fichtenbaum
Twenty-First Securities Corporation
Reprinted with permission from Derivatives Report, Copyright © 2000, Warren, Gorham & Lamont, Division of RIA, 395 Hudson Street, New York, NY 10014. 1-800-431-9025.

For non-affiliated employees wishing to hedge highly appreciated employee stock options, an analysis must be undertaken to decide which hedging tool should be used: swaps, options themselves or forward contracts.

Updates: Hedging Nonqualified Stock Options (Spring 2004). Hedging Nonqualified Stock Options Revisited (Summer 2004). No-Action Letter Says Insiders Can Collar Options (May 2004).

Over the last few years, many individuals have received from their employers both "nonqualified" and "qualified" stock options that have significant value due to the appreciation in price of the underlying stock. Very recently, a lot of attention has been given the subject, due to Dick Cheney's holdings of employee stock options in Halliburton. Many of the news articles have discussed how Cheney could attempt to remove his conflict of interest by limiting his economic risk in Halliburton through various hedging techniques.

Unfortunately, as discussed more fully below, the solutions offered to Cheney only create a new conflict of interest - the holding of a synthetic put. The New York Times pointed out the further complication of possibly creating ordinary income and capital losses with these well-intentioned but badly constructed hedges.¹

This article examines the tax, economic, and regulatory issues facing all holders of stock options. It then focuses on Cheney's particular situation and what we believe would have been his best course of action.

TAX CONSEQUENCES

The tax consequences of hedging employee stock options could very well mirror those of hedging the underlying stock. By way of background, Section 1259 sets out conditions in which a taxpayer will be treated as having constructively sold an "appreciated financial position." An "appreciated financial position" is a position with respect to any stock if there would be gain when that position was sold, assigned, or otherwise terminated at its fair market value.

Constructive Sales Rules

A basic question is whether an employee stock option is subject to the constructive sales rules. If the option is terminated at its fair market value, the termination will give rise to compensation income as opposed to "gain." Throughout the Code, the word "gain" is used when an asset is disposed of, typically in a capital transaction. A number of practitioners consider that this distinction between gain and compensation leads to the conclusion that employee stock options are not governed by the constructive sales rules. However, Section 1001 defines "gain" as the excess of the amount realized over the basis in the asset disposed of. Thus, while there would be gain on the disposition of an option, that "gain" would be treated as compensation income. Consequently, a more conservative conclusion is that employee stock options are covered by the constructive sales rules.

Assuming employee stock options are covered by the constructive sales rules, for the hedging transaction not to trigger gain, it must be carefully constructed. The hedge must not eliminate substantially all the risk of loss or potential for gain in the employee options. Unlike a holder of stock that has risk of loss all the way down to zero, an option holder only loses its in-the-money value. Thus, a short sale that makes money all the way to zero will protect gains down to the strike price (locking in the in-the-money value at hedge execution) and then start making new profits as the stock declines below the strike price. This "synthetic put" is the new conflict mentioned earlier in Cheney's situation. It is interesting to con template whether a short could avoid constructive sales treatment due to the possibility for gain if the equity drops below the strike price of the calls. However, the additional profit is a result of the new position and not of the pre-existing employee option position.

The collar could be implemented using a variety of tools - options themselves, prepaid variable  forward contracts, and swaps with embedded options.

Solution: Collar Product 

If the possibility for profit does not remove the hedge from the constructive sales rules, a short sale would be inappropriate and some type of collar should be used. The investor should retain some profit potential and/or risk of loss through the "collar product."  Based on the legislative history accompanying the implementation of the constructive sales rules, the exposure to the stock should be equal to at least 15% of its value, and the hedge should have a limited life (say five years). The collar could be implemented using a variety of tools. Three tools that are commonly used are options themselves, prepaid variable forward contracts, and swaps with embedded options. While all three accomplish the same economic goal, they each have different tax consequences.

Since Cheney's options are "non-qualified," the Times observed that any subsequent appreciation in the employee options is treated as compensation income, while any counter-balancing losses on the hedge are treated as capital. This would create the classic whipsaw of ordinary income that cannot be offset by capital losses. We believe this can be avoided by using swaps, as opposed to options or forwards.

The best course of action for Cheney would be to enter into a swap that incorporated options on Halliburton with identical strike prices and expiration dates as his own options.

Proposed Regs Could Make Swaps Less Attractive (May 2004).

Swaps. With a swap, if the underlying stock continues to rise after the hedge has been put into place, a loss may be incurred. The loss will be manifested through periodic payments made by the employee to the counterparty on the swap. In a Technical Advice Memorandum (TAM 97340007), the IRS ruled that all contractual payments made under a swap, including the final payment, must be treated as an ordinary deduction. Therefore, both the subsequent appreciation on the option and the loss on the hedge will be treated as ordinary deductions and be tax neutral. The potential negative result from this transaction is that the ordinary deductions relating to the swap payments are probably treated as an "other itemized" deduction. These deductions may only be taken to the extent that, in the aggregate, they exceed 2% of the employee's adjusted gross income. Thus if the deductions are limited by these rules, then, while the character of the income and expense remain the same, the amounts will differ.

Option-based collar or forward contract. On the other hand, the use of an option-based collar or forward contract would give rise to capital treatment. Therefore, if the underlying stock continued to appreciate, the employee would have ordinary income and capital losses. Unless the employee had capital gains from other sources, the losses would not be deductible. In that event, for every $1 rise in the price of the stock, the employee would lose 39.6¢ on an after-tax basis, an expensive price to pay due to the use of the wrong hedging tool.

If the employee had capital gains to be offset by the losses, this becomes less important. Caution should be exercised for the gains to be considered short-term gains, taxable at 39.6%. Otherwise, ordinary income from further appreciation would be taxed at twice the rate of savings produced by the "offsetting losses."

Counterparty's concern. The counterparty to the swap would need to be sure that the employee would be able to perform under the swap. The counterparty would take into account various factors in its decision, including the employee's overall financial position, whether the options have vested, and the remaining life of the options. Based on these considerations, the counterparty could reject the transaction or demand collateral other than the employee options, or, to the contrary, actually lend the employee money against the now-hedged employee option position.

Qualified options. For employees with "qualified" or incentive stock options, while the same considerations regarding the constructive sales rules and collateral would apply, there would not be a concern of mischaracterization of the income and loss. When a qualified option is exercised, there is no recognition of income. The income is recognized when the employee sells the stock, and that income is treated as capital gain. Therefore, the hedges producing capital losses might actually be preferable to those creating ordinary deductions because there is no 2%-of-adjusted-gross-income limitation. Since the qualified option produces capital gain, it should be covered by the constructive sales rules.

REGULATORY, ECONOMIC CONCERNS

A regulatory concern that would impact all of the above-mentioned techniques is the employee's status. If the employee is an affiliate of the corporation, the employee can only enter into such a transaction covering a number of shares that the employee actually owns. Options are not deemed ownership of the underlying stock for these purposes, regardless of how deep in the money they are. Therefore, unless an affiliate owned a similar amount of shares, the transaction could not be used to hedge the employee options. It is a matter for discussion whether an affiliate could sell options "mirroring" the terms of the employee options, since it could be argued that the affiliate does own the underlying asset (that being the economics of the employee option).

DICK CHENEY'S SITUATION

While Dick Cheney has all of the above tax and regulatory issues to deal with, he must also deal with a potential conflict-of-interest issue. The advice offered to Cheney was to hedge his employee options through the use of an option-based collar. As discussed above, since his options are nonqualified, this strategy would create a character mismatch between his income and expense for tax purposes. More importantly, since Cheney's options have strike prices ranging from 28½ to 54½, the creation of a synthetic put would create a new conflict of interest. Thus, if Cheney as Vice-President did something to harm Halliburton, he would earn a profit as the price of Halliburton fell below the strike price of his options.

In our opinion, the best course of action for Cheney would be to enter into a swap that incorporated options on Halliburton with identical strike prices and expiration dates as his own options. This would remove all conflict of interest and avoid the mischaracterization of income and expense.  However, this strategy could accelerate the recognition of taxable income because of the constructive sales rules. Maybe Cheney could see the complexity and unfairness in these rules and use his influence as Vice President to rectify the situation.

CONCLUSION

For non-affiliates wishing to hedge highly appreciated employee stock options, an analysis must be undertaken to decide which hedging tool should be used. The type of employee option held, qualified or non-qualified, seems to be the major determinant in deciding the hedging tool. For nonqualified employee options, the strategy that seems best is a swap that creates ordinary deductions (while the amount of the deduction may be limited). For qualified employee options, the strategy that appears best is a forward contract or option-based collar, which could result in capital losses.

Robert Gordon is President and Mark Fichtenbaum is Tax Director of Twenty-First Securities Corporation in New York City. Robert Gordon is a member of the Derivatives Report's Editorial Advisory Board.

Endnotes:

1.         The New York Times, August 26, 2000.