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   Selected Articles by Twenty-First Securities Authors

Hedging Non-qualified Stock Options
By Peter Brady, Esq. and Robert N. Gordon
Twenty-First Securities Corporation
Originally published in Journal of Taxation of Investments (Spring 2004 Issue)

For background information, see Hedging Appreciated Employee Stock Options: Tax, Economic, And Regulatory Concerns (written in 2000).
For an update, see Hedging Non-qualified Stock Options Revisited (Summer 2004).
No-Action Letter Says Insiders Can Collar Options (May 2004).

The volatility in equity markets over the past several years has increased the desire of many individuals to hedge their exposure to concentrated positions in a single stock.  One area in which individuals often wish to hedge their exposure to a particular stock is in the context of non-qualified stock options
1.  This article addresses the key issues related to hedging non-qualified stock options, discusses the various strategies that are commonly employed, and identifies two potential strategies that could provide the best results for most individuals.

Investor Objectives

An employee stock option entitles the holder to buy a specific number of shares from his employer at a specified price (“the exercise price”).  For example, a company may grant options giving the executive the right to purchase 100,000 shares at a price of $20 per share beginning in five years and expiring in ten years.  Even if the current stock price is below the exercise price, the option has value2 since the executive has the right, not the obligation, to purchase the stock at the exercise price.  If the current stock price is above the exercise price of the options, the options are said to be “in the money.”  When NQOs are in the money, executives often wish to “lock in” some portion of their unrealized gain prior to exercise. Ideally, an executive who has a significant amount of wealth tied up in appreciated NQOs would like to protect this gain by hedging against a decline in the stock price prior to exercise3.  In order to accomplish this result, the executive must choose a hedging tool that removes some, or all, of the risk of holding the employee options without creating a current tax liability.  Moreover, the executive must hedge his employee options in a manner that does not violate any contractual or securities law restrictions.  In the past, investment banks have offered a number of different products and strategies designed to accomplish these goals.  However, many of these strategies create tax issues that may outweigh any potential benefits of hedging.  Therefore, executives, and their advisors, must be very careful when selecting a tool to hedge NQOs.

Tax and Regulatory Issues

Although the primary focus of this article is on the tax aspects of NQO hedging, there are also potential contractual and securities law constraints on an executive’s ability to hedge.

Contractual limitations to employee options hedging

Most firms limit the ability of executives to exercise NQOs via contractual “vesting periods”, which specify the time frame in which employee options may be exercised.  However, direct contractual limits on employee options hedging are relatively uncommon. While most employee option plans forbid transfer or assignment of the option4, they typically do not forbid hedging.  Nevertheless, as a practical matter, it is both imprudent and unlikely that an executive would be able to hedge unvested employee options5.  Another common contractual constraint is that most option plans prevent executives from pledging their grants. This restriction can be important because most securities dealers require executives to post some form of valuable collateral for a hedging transaction.  Because the employee option typically cannot be used as collateral, the executive must typically pledge other assets as collateral with the securities dealer that executes the hedge.  Often the executive will own other company stock that can be pledged as collateral. If the executive does not have other company shares to pledge as collateral, he will have to post another form of collateral whose value may or may not track his obligation under the hedging contract.

Securities law limitations to employee options hedging

The main securities law constraint on employee options hedging is section 16(c)6.  This rule makes it illegal for affiliates to sell their employer's stock short.  The statute disallows only short sales and does not address derivatives that offer similar economic results to a short sale.  Rule 16c-4 specifically permits affiliates to employ derivatives to hedge.  However, this rule allows affiliates to hedge only to the extent of their ownership of underlying shares of company stock7.  Therefore, while affiliates can hedge their stock positions, they cannot hedge NQOs8.

Another possible securities law constraint to employee options hedging is Rule 10b-5, which imposes liability for trading based on inside information.   As long as an executive’s desire to hedge is not based on material, non-public information, Rule 10b-5 should not pose any serious problems.

A final issue to consider is the "short swing profit" rules of section 16(b). In general, this rule allows the firm to recover any profit the firm's insiders earn from buying and selling issuer stock or derivatives on this stock within six months.  This problem can generally be avoided by not buying any stock within six months of hedging.  An executive can hedge within six months of an employee options grant, because the grant of employee options should not be a “matchable” transaction9.

Tax law limitations to employee options hedging

Under the “constructive sale” rules10, investors cannot enter into certain transactions that have the effect of hedging away all of the upside and downside risk of holding an “appreciated financial position.”11  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.  These rules were enacted in 1997 and were designed to eliminate certain hedging and monetization strategies that were perceived to be abusive.  A basic question is whether an NQO is subject to the constructive sales rules.  If an NQO 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 believe 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.  If the constructive sales rules did not apply to NQOs, an executive could hedge his NQOs by selling call options in the marketplace that mirror the terms of the options he owns.  For example, if an executive has NQOs with an exercise price of $10 that expire in three years, he could sell call options in the marketplace with the same strike price and expiration date, thereby immediately realizing the current value of his NQOs.

Assuming that the constructive sale rules apply to NQOs, a number of different hedging strategies that produce “collar-like” economics remain.  In a typical “collar”, an investor purchases a put option, which gives him the right to sell the underlying security at a specified price, and sells a call option, which gives the buyer the right to purchase the stock from him at a specified price.  By combining the purchase of a put with the sale of a call, the investor creates a “collar” around the price of the stock.  For example, an investor who owns shares of XYZ stock that is currently trading at $20 could purchase a put option with a strike price of $19 and sell a call option with a strike price of $26.  This would protect the investor from any price declines below $19 and cap the investor’s upside participation at $26. 

As long as a hedge does not eliminate substantially all of the risk of loss and potential for gain in the employee options, it should not create a constructive sale. An interesting question that arises in this context is whether a non-affiliate who hedges NQOs must maintain any upside participation in either the NQOs or the underlying stock.  For example, if an employee who is not an affiliate owns NQOs and enters into a short sale, he will have eliminated all economic exposure to either the NQOs or the underlying stock.  However, the employee will retain an opportunity for gain should the stock price drop below the strike price of the NQOs.  This opportunity for gain comes from the short position continuing to accrue profits as the stock drops below the strike price of the options, not from the NQO12. Although this would seem to create a conflict of interest, since the employee is now in a position to benefit economically if his company’s stock price declines, it should not be a constructive sale because there is the possibility for a windfall if the stock drops.  It should be noted that this same potential to profit when the company’s stock declines would also exist if an employee hedges his NQOs with a collar.  For example, assume that an executive executes the same collar on XYZ stock described above (purchasing a put with a strike price of $19 and selling a call with a strike price of $26 at a time when XYZ stock is worth $20.)  If the executive owns NQOs with an exercise price of $10, he will reap additional gains if the stock price drops below $10.

In the context of hedging stock, as opposed to NQOs, an individual who enters into a short sale13of the stock clearly has made a constructive sale.  However, if an executive owns NQOs, a short sale of the underlying stock will not automatically create a constructive sale, since the NQOs are not “substantially identical” to the underlying stock14.  The bottom line is that an executive looking to hedge NQOs must be careful to structure the hedge so that he maintains sufficient opportunity for gain or loss to avoid creating a constructive sale.  If the executive is an affiliate, his ability to hedge is further constrained by securities law restrictions.

Hedging with a collar

As mentioned above, executives can hedge their NQOs and retain some profit potential and/or risk of loss by employing some type of “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.  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.

Possible Hedging Tools

Option-based collars or forward contracts

The key issue that arises when hedging NQOs is the potential “whipsaw” that can occur if the hedging tool and the employee options produce income/loss of different character.  When an executive exercises an NQO, it gives rise to ordinary income15.  By contrast, an options-based collar or forward contract will give rise to capital gain or loss. Therefore, the use of an option-based collar or forward contract to hedge NQOs creates the potential for ordinary income on one side of the transaction and capital loss on the other side.  If the underlying stock continues to appreciate, the employee will have ordinary income and capital losses. Unless the employee had capital gains from other sources, the losses would not be deductible.

For example, assume that an executive hedges his NQOs using an options-based collar and that the underlying stock increases by $1 million above the level of the sold call options while the hedge is in place.  Economically, the client has not benefited from this increase since he traded away his upside participation in the stock beyond this level.  However, when the collar matures and the executive exercises his NQOs, the executive now has an additional $1 million of ordinary income and $1 million of capital losses.  Unless the executive has sufficient capital gains against which he can offset these capital losses, he can only deduct $3,000 of the capital loss against ordinary income.  Therefore, while this hedge provided downside protection, it also created $997,000 of ordinary income in the current year.

One way around this issue would appear to be for the NQO recipient to make an election under Section 83(b) of the code.  This section allows employees who receive property from their employers to elect to be taxed upon receipt of the property at ordinary rates for the fair market value of the property.  Any subsequent appreciation in the property is then taxed as capital gain.  However, a section 83(b) election is available only for options that have a “readily ascertainable value.”  Under Treas. Reg. 1.83-7, in order for an option to have readily ascertainable value, it must either trade on an established securities market (which is not the case for NQOs), or it must meet four other criteria that, in practice, NQOs are unlikely to ever meet16.  Therefore, an election under Section 83(b) is not feasible for NQOs.

Section 1221-2(b) Election

One possible solution to the whipsaw problem that some experts have proposed is for the executive to identify whatever hedging strategy is used as a hedging transaction within the meaning of U.S. Treasury Regulation section 1.1221-2(b)17.  This section defines a hedging transaction as “a transaction that a taxpayer enters into in the normal course of the taxpayer's trade or business primarily - (1) To reduce risk of price changes or currency fluctuations with respect to ordinary property...” This section was designed to protect businesses that employ hedging transactions in the ordinary course of their business.  For example an airline might hedge the price risk on jet fuel through forward contracts.  Section 1221 would allow these companies to treat any gain or loss from their hedge as ordinary, since the underlying asset being hedged is ordinary (in this example, the asset being hedged is the company’s raw material). In addition, if a transaction is identified as a hedge under Section 1221, the recognition of income or loss from the hedge is matched with asset or liability that is being hedged.

In order for Section 1221 to apply to hedging NQOs, two conditions must be met.  First, the NQOs have to be “ordinary property.” Second, the hedge must be entered into in the ordinary course of the executive’s business.  With respect to the first issue, the NQOs should be considered “ordinary property”, since they were granted in return for the executive’s work on behalf of the company and upon exercise, the executive will recognize ordinary income.    A recent Private Letter Ruling18 provided further guidance about the application of Section 1221 when a derivative is used to hedge in the context of employee compensation.  This ruling involved an employer that offered deferred compensation to its employees.  The amount of the deferred compensation was based upon the performance of certain mutual funds.  Rather than investing directly in the mutual funds, the firm chose to hedge its deferred compensation liability by entering into a derivatives contract with a securities dealer.  The firm identified the derivatives contracts as hedging transactions pursuant to Section 1.1221-2(f).  The ruling held that the deferred compensation obligation was an “ordinary obligation” and that the derivatives contracts qualified as hedging transactions for purposes of Section 122119.  This ruling provides further support for the position that NQOs are “ordinary property.”  The ruling states that the employer’s deferred compensation liability is an “ordinary obligation” under Section 1.1221-2(c)(2) because “an obligation is an ordinary obligation if performance or termination of the obligation by the taxpayer could not produce capital gain or loss.”  Although NQOs are an asset, rather than a liability, in the hands of an employee, the same analysis should apply.  That is, upon exercise or other disposition of the NQOs, the employee will not produce capital gain so they should qualify as “ordinary property.” 

The second condition that must be met in order for Section 1221 to apply in the context of hedging NQOs is that the hedge must be “entered into in the normal course of the taxpayer’s trade or business primarily [t]o reduce risk of price changes…”By entering into a hedging transaction, the executive is reducing price risk of the NQOs.  The executive must also demonstrate that the hedge is one that he does in the “normal course” of his business.  This is a somewhat novel tax argument, and not all practitioners agree with its application.  However, if Section 1221 can be used by an executive in the context of hedging employee options, it provides a simple solution to the whipsaw problem.  Any loss on the hedge would be of the same character (ordinary) as the income from the NQOs. 


For those executives who are not completely comfortable that Section 1221 can be applied to hedging NQOs, another possible alternative is to use a swap that has built in collar-like economics20. 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 Memorandum21, 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.  So, swaps solve the whipsaw problem by matching the character of income from the employee options with the income from the swap.  However, there are several potential drawbacks to swaps.

One potential negative result from this transaction is that the ordinary deductions relating to the swap payments are probably treated as an "other itemized" deduction22. 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.  In addition, ordinary swap losses offer no deduction for purposes of calculating Alternative Minimum Tax (AMT) liability23.  The AMT was originally designed to ensure that wealthy individuals who had a great deal of deductions paid at least some income tax.  Individuals are required to calculate their adjusted gross income first under the normal rules of income tax.  Then they must make a separate calculation of their potential AMT liability.  A number of exclusions and deductions that are allowed for income tax purposes are disallowed for purposes of calculating the AMT.  For example, certain types of municipal bond interest are taxable for AMT purposes and no deduction is allowed for payment of state and local taxes.  An executive with sizable employee options income, offset by an equal amount of swap expenses, cannot deduct the swap expenses for purposes of calculating his AMT liability.

In addition, on February 26, 2004, Treasury issued proposed regulations24 that could potentially have additional adverse consequences for swap participants.  These regulations address the timing and character of “contingent nonperiodic payments” made pursuant to a notional principal contract (a swap).  A typical equity swap involves at least two types of payments between the dealer and the counterparty.  For example, assume that an investor wishes to enter into a “total return swap” on XYZ stock.  Economically, this is equivalent to a leveraged purchase of XYZ stock.  Therefore, the investor will typically agree to make periodic payments to the dealer to reflect the cost of borrowing.  In addition, the investor will agree to pay the dealer for any depreciation in XYZ stock at maturity of the contract while the dealer will agree to pay the investor an amount reflecting any appreciation in XYZ, plus an amount reflecting the total dividend income and any other distributions paid to holders of XYZ during the term of the swap.  The periodic payments made by the investor are not contingent, since the rate to be paid typically will be stipulated when the contract is initiated.  Because these payments are periodic and noncontingent, they would be currently deductible by the investor (and includable in the income of the counterparty).  By contrast, the payment reflecting any appreciation or depreciation in XYZ25 is both contingent and nonperiodic.  The amount to be paid (or received) by the investor cannot be determined until maturity of the swap, since it is based on the price of XYZ at maturity, so it is clearly contingent.  Moreover, unlike the interest payments that are made during the life of the swap, this payment typically occurs at maturity and thus is nonperiodic.  Prior to issuance of the proposed regulations, most taxpayers adopted a “wait and see” methodology whereby they only included contingent nonperiodic swap payments into income once the amount of the payment was determined (i.e. at maturity of the swap).

Under the proposed regulations, taxpayers will no longer be allowed to use the “wait and see” approach.  Instead, taxpayers will be required to include nonperiodic payments in taxable income over the term of the swap.  The proposed regulations also clarify that the character of both periodic and nonperiodic payments, including any payments made at maturity of a swap, is ordinary.  This new regime could create the potential for a tax on “phantom income” in the context of hedging NQOs.  For example assume that an executive enters into a swap with an embedded collar on XYZ stock.  Assume that the stock has a value of $100 per share when the swap is initiated, the swap is for a term of two years26 and that under the terms of the swap, the executive agrees to pay the swap dealer for any appreciation in XYZ stock above $120 per share and the dealer agrees to pay the executive for any decline in XYZ stock below $100 per share.  Assume that after one year, XYZ drops to $75 per share.  Under the proposed regulations, the executive would have to include in income an amount to reflect the increase in value of the swap27.  Now assume that price of XYZ recovers and rallies to $150 per share at maturity of the swap.  At this point, the executive will recognize an ordinary loss on the swap, subject to the limitations set forth above.  Under the “wait and see” method, the executive would not have recognized income related to “contingent” payment until maturity of the swap.  In the example above, under the proposed regulations, the executive will be taxed at the end of the first year on a “phantom” gain and will ultimately recognize an ordinary loss that may or may not be fully deductible.  For swaps that terminate within a single tax year, the proposed regulations should not have any impact.  However, for longer swaps, the proposed regulations have the potential to create a very undesirable tax result.

Size and collateral issues

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.

Another issue to consider is that most brokerage firms are unwilling to enter into swap contracts whose notional value is less than $3 million dollars.  In addition, in order to be a “qualified swap participant” an individual must have a minimum of $10 million of assets (this is gross assets, not net worth, and can include real estate and other illiquid assets).  Therefore, swaps are not an appropriate hedging tool for executives who do not have a significant amount of NQOs and other wealth.


It is clear that there is a great deal of demand among executives to hedge NQOs.  However, hedging these options is not always simple.  There are a number of tax issues that must be considered when choosing a hedging tool for NQOs.  The two primary issues that must be addressed are the constructive sale rules and the potential for a “whipsaw” of ordinary income and capital losses.  Structuring a hedge that avoids the constructive sale rules is relatively straightforward.  The “whipsaw” issue is more complex.  We identified two strategies that potentially avoid this issue.  However, both of these strategies have potential limitations or drawbacks that must be analyzed before implementing the hedge.

1 There are two main types of employee options:  “incentive” stock options (“ISOs”) and “nonqualified” options (“NQOs”).   Under I.R.C. Sec. 421(a)(1), an ISO is taxed at capital gain rates and the tax is deferred until the employee sells the stock received upon exercise of the option.  Incentive stock options comprise only a small percentage of most senior executive's compensation because the dollar value of annual ISO grants is limited. See I.R.C. 422(d) (underlying stock cannot be worth more than $ 100,000 for annual ISO grant).  Under Treas. Reg. 1.83-7(a), an NQO is taxed as ordinary income upon exercise.

2 The value of an option consists of two elements:  “time premium” and “intrinsic value.”  Intrinsic value is simply the difference between the exercise price of an option and the current share price.  If a stock is currently trading at $50, an option to buy that stock for $40 has $10 of intrinsic value.  However, as long as there is time remaining before the option expires, the option will be worth more than $10 because there is a chance that the stock price will rise above $50.  The amount by which the option’s price exceeds its intrinsic value is called “time premium.”  To calculate the total value of the option, traders use sophisticated pricing models, such as the Black-Scholles model, which estimate the value of the option based on six main factors:  exercise price of the option, price of the underlying stock, time to expiration, volatility of the underlying stock, interest rates and expected dividend payment of the underlying stock.  In theory, an executive who owns out of the money employee options could still capture the value of the time premium in these options by selling identical options that are trading in the marketplace.

3 Once the options are exercised, an executive can diversify by simply selling the underlying shares.  Because the executive will be taxed on the amount of gain upon exercise (measured by the difference between the exercise price and the stock price at the time of exercise), the executive’s basis in the shares will be equal to the fair market value of the stock at the time of exercise.  Therefore, if the shares are sold immediately after the options are exercised, there will be no capital gain at this time.

4  See, e.g., Microsoft Corporation, Proxy Statement Pursuant to Section 14(a) of the Securities Exchange Act of 1934, Sep. 29, 2003, Sec. 2 (“Nontransferability of Awards.    Unless otherwise determined by the Committee, awards granted under the Stock Plan are not transferable other than by will or the laws of descent and distribution and may be exercised during the awardee’s lifetime only by the awardee.”)

5 Hedging unvested employee options presents some significant issues.  For example, there is a risk that the employee could lose his job before the options vest, which in most cases would terminate the employee’s ownership of the options.  If an employee enters into a hedging transaction with respect to unvested employee options and then loses his job, the hedging transaction would actually become a speculative bet against the value of the underlying stock.  Clearly, that was not the employee’s intent when he entered into the hedge.  Because of this risk, it is unlikely that most securities dealers would allow an executive to hedge unvested options unless the executive posts significant valuable collateral to compensate for this risk.

6 See Securities Exchange Act of 1934, 16(c), 15 U.S.C. 78p(c) (1994) (“It shall be unlawful for any affiliate... directly or indirectly, to sell any equity security of such issuer... if the person selling the security or his principal... does not own the security sold....”).

7 See 17 C.F.R. 240.16c-4. The rule permits “put equivalent positions” (i.e., derivatives that appreciate as the stock price declines), but only "so long as the amount of securities underlying the put equivalent position does not exceed the amount of underlying securities otherwise owned."  For example, an insider can buy a put on 500 shares if he owns 500 shares, but not if he owns only an option to buy 500 shares.     The term “put equivalent position” is defined as “a derivative security position that increases in value as the value of the underlying equity decreases, including, but not limited to, a long put option and a short call option position.”

8 The viewpoint of the SEC on this matter is not entirely free from doubt, but this is certainly the more conservative view.  Affiliates should consult with their own advisors before deciding whether they feel comfortable hedging NQOs.

9 See 17 C.F.R. 240.16b-3(d).

10 I.R.C. Sec. 1259

11 It should be noted that for purposes of IRC Sec. 1259, the legislative history indicates that the statute is designed to prevent transactions that eliminate “substantially all of the taxpayer’s risk of loss and opportunity for income or gain with respect to [an] appreciated financial position.” (emphasis added).  Therefore, there should not be a constructive sale where a taxpayer eliminates only one of these elements.  In other words, a taxpayer who owns appreciated stock, or options, may eliminate all risk of loss (for example by purchasing an at-the-money put option) as long as he retains an opportunity for gain.

12 When an individual hedges stock, hedging gains are typically offset dollar-for-dollar by a corresponding decline in the value of the stock.  By contrast, when an individual hedges NQOs, gains from the hedge can exceed the decline in value of the NQO.  For example, if an employee owns NQOs with an exercise price of $10 and enters into a synthetic short sale when the stock is worth $25, the employee has eliminated any possibility of additional gain from appreciation of the underlying stock and NQO.  However, the employee has retained the opportunity for additional gain if the price of the underlying stock drops below $10.  If the employee is an insider, he would not be able to enter into this type of transaction.  An insider can only hedge NQOs to the extent of his ownership of company stock. 

13 Or a derivatives-based structure that is economically equivalent to a short sale.

14 There may be circumstances in which a taxpayer would be deemed to have entered into a short sale of “substantially identical property” even if he only owns NQOs and shorts the underlying stock.  This would depend upon how “deep in the money” the NQOs are.  For example, if an executive who owns NQOs with a strike price of $1 enters into a short sale of the underlying stock at a time when the stock is trading for $100 per share, this would undoubtedly be a constructive sale.  An option that is very deep in the money is economically so similar to owning the underlying shares that a short sale of the underlying shares would be a short sale of “substantially identical property.”  As mentioned in note 8 above, this issue is irrelevant for insiders since insiders cannot sell short company stock.

15 See note 1 above

16 Specifically, the rule stipulates that for an option to have readily ascertainable value, the option must meet the following criteria: (1) the option is transferable by the optionee, (2) the option is exercisable immediately, (3) the option or the property subject to the option is not subject to any restriction which has a significant effect upon the market value of either the option or property, and (4) the fair market value of the option must be able to be estimated with reasonable accuracy.  In practice, NQOs are almost always non-transferable and are usually not immediately exercisable.

17 Under these regulations, the employee must identify the NQOs as part of a “hedging transaction” within 35 days after the hedge is initiated.

18 PLR 200415009

19 Interestingly, the PLR indicated that, had the employer hedged its risk by investing directly in the mutual funds to which it deferred compensation liability was tied, this would not qualify as a hedge under Treas. Reg. Section 1.1221-2(d)(5).  This is a somewhat anomalous result, which is not clarified in the PLR.

20 A swap with a built-in collar would be structured such that the swap dealer agrees to pay the employee for all for all depreciation in the underlying stock below a certain level and the employee agrees to pay the swap dealer for all appreciation above a certain level.

21 TAM 97340007

22 The deduction under Treas. Reg. 1.446-3 (1994) for swaps is usually considered an expense for the production of income under section 212.

23 See I.R.C. 56(b)(1) (disallowing deduction of miscellaneous itemized deductions in computation of alternative minimum taxable income)

24 Treas. Reg. 166012-02

25 Including an adjustment for dividends paid

26 For simplicity, assume that the swap begins on January 1 of Year One and ends on December 31 of Year Two and that the taxpayer reports income on calendar-year basis.

27 Because the swap is designed to hedge the executive’s exposure to XYZ stock, the swap will increase in value when the stock price declines.  The proposed regulations specify more than one method for including contingent payments into income during the term of the swap.  For the sake of simplicity, we have assumed that the mark-to-market method is used.


This article and other articles herein are provided for information purposes only.  They are not intended to be an offer to engage in any securities transactions or to provide specific financial, legal or tax advice. Articles may have been rendered partly inaccurate by events that have occurred since publication.  Investors should consult their advisers before acting on any topics discussed herein.

Options involve risk and are not suitable for all investors.  Before engaging in an options transaction, investors must review the booklet "Characteristics and Risks of Standardized Options".  


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