Option Technique Is Patent Nonsense

Patent issued for dangerous idea

By Kaye A. Thomas
Posted March 10, 2008

Hedging your options can lead to disaster.

United States patent number 7,337,141 has been granted for an "invention" making it possible to hedge employee stock options — in other words, protect against loss of value in those options without cashing them in. Potential problems in using the technique make it unsuitable for nearly all option holders.

The "invention"

Patents are granted for inventions, and in this case the "invention" involves the use of vested employee options as collateral. If you hold vested employee options and want to use this technique, you would provide your broker with an exercise notice for your options. It would be similar to the exercise notice you would use to cash out your stock options, but it would instruct the company that granted the option to deliver shares to the broker. The broker would hold onto the exercise notice, using it as collateral against a sale of a non-employee option on the same stock. A key part of the patent document is a dubious claim that the option holder can avoid adverse tax consequences connected with the transaction.

Patents involving tax techniques are controversial. There is concern that taxpayers will mistakenly believe that a tax-saving technique that receives a patent must be a valid one. Many observers object to the notion that taxpayers should be required to pay royalties to gain access to a tax-saving technique. The IRS has proposed to issue regulations classifying patented tax techniques as "listed transactions," meaning the taxpayers would be required to provide special disclosure of these transactions on their tax returns, inviting close scrutiny. Legislation has been proposed to prohibit the granting of these kinds of patents.

Suppose your company granted you stock options with an exercise price of $100,000 before a dramatic rise in the stock value. The options are now vested and you can cash them in for a profit of $1,000,000, but they won't expire for a while. You may feel that you want to continue holding the options, but if the stock falters you could see much of your $1,000,000 profit disappear. Using this patented technique, you would provide your broker with an exercise notice for the employee options, and the broker would sell non-employee options on the same stock. If the stock goes south, you make a profit on the option you sold that makes up for the loss you take on the employee option. You get to continue holding your employee option without a risk of loss.

There's a flip side to this equation. While reducing or eliminating the loss you would have if the stock goes down, you also reduce or eliminate the gain you would have if the stock goes up. The added profit on the employee option you continue to hold would be offset by a loss on the non-employee option you sold. The "invention" doesn't produce risk-free profit. Potentially, though, it allows you to capture a larger profit from your employee option. If you simply cash in your $1,000,000 profit, you abandon the remaining time value of the option. The purchaser of the non-employee option your broker will sell on your behalf will in effect be buying this time value from you.

How much value?

Most people would think of using this technique only in a situation like the one described above, after a dramatic rise in the stock value leaves them with a large profit they want to protect. In that situation, the amount of time value left in the option is relatively insignificant even if the option still has several years left until it expires. This is because time value is always a fraction of the exercise price of the option, and not a fraction of the overall value. In the example above, the option's time value is a fraction of $100,000, and a small fraction at that. If the time value is somewhere around $20,000, as seems likely, the transaction costs of using this technique (which requires selling over $1,000,000 worth of options) may exceed the benefit. In other words, you're better off simply cashing in the employee option, even though that means abandoning some time value.

Time value is more important when the amount of profit built into an option is small. But in that case, the amount of cash needed to exercise the employee option is large in relation to any built-in profit. You may need to provide additional collateral for the option sale. In any case, few people want to hedge their options when there isn't much profit built in.

Company policy

Most publicly traded companies have a policy that prohibits employees from betting against the company's stock. Selling a non-employee option as described above would violate such a policy and could be grounds for termination of the employee. No one should use this planning technique without first receiving assurance that the company won't object.

It's hard to imagine why a company would offer such assurance. One of the main points of granting options in the first place is to align the financial interests of employees with those of stockholders. The idea is that the company will prosper if the people working there know they'll benefit from an increase in the stock value, and suffer a detriment if the value declines. Allowing employees to hedge against their stock options undercuts a major purpose of the stock option program.

Tax whipsaw

Another major problem with this technique is the potential for a tax whipsaw. A major increase in the stock value could produce a painful result. Here's how it works.

Recall that at the same time you protect against a slide in the stock value, you give up the benefit of an increase. If the stock price goes up while you're using this technique, you have a greater profit from the employee option but a corresponding loss from the option you sold. In terms of basic economics this isn't a problem: you have, say, $2,000,000 of profit on one side and $2,000,000 of loss on the other. You may be kicking yourself over losing the opportunity for an added $2,000,000 of profit, but perhaps you can be philosophical in light of the loss protection you achieved.

The added profit on your employee option, though, is ordinary income. The entire amount is included in your taxable income. The corresponding loss on the non-employee options would normally be a capital loss, however. You're allowed to use an unlimited amount of capital loss against capital gain, but you can use only $3,000 per year against ordinary income. As a result, even though your $2,000,000 profit on the employee option is economically offset by a $2,000,000 loss on the non-employee option you sold, you have to pay tax on the $2,000,000 profit while getting a deduction of only $3,000 for the loss. Economically you just broke even, but you're stuck with a tax bill of about $700,000, not including any state income tax you may owe.

A dubious solution

The patented technique offers a solution that involves treating the sale of the non-employee option as a "hedging transaction" as defined in the tax law. The rule allowing certain transactions to be treated this way is designed for situations where taxpayers seek protection against losses they may incur in the ordinary course of a trade or business. A jeweler, for example, might hedge against a change in the price of precious metals. The patent document suggests this rule could be applied to the sale of a non-employee stock option to hedge an employee stock option.

There is some reason to doubt that you are pursuing a "trade or business" as required for this rule when you provide services as an employee. Although employees have been found in certain contexts to have a trade or business, it isn't clear that the concept would extend to this situation. If your work as an employee isn't considered a trade or business for this purpose, you can't treat the sale of a non-employee option as a hedging transaction under the tax law.

There's another hurdle that may be more difficult. It isn't enough to establish that you have a trade or business. Your hedging transaction must be "in the ordinary course" of that trade or business. It's certainly possible to make the argument, but it seems a stretch to say that selling a non-employee option is something that would be done in the ordinary course of one's activities as an employee.

We don't have guidance from the IRS or rulings from the courts on these issues. Until the question is settled, anyone using this technique is exposed to risk that it will lead to a tax disaster.

Bottom line

Relative to the approach of simply cashing in an option when the profit becomes large, the patented technique typically offers a relatively small advantage while creating hefty transaction costs, a violation of company policy at most firms, and the risk of a painful tax result. When you need to reduce the risk of holding employee stock options, the best approach in nearly all cases is the obvious, easy, inexpensive one: exercise some or all of the options and sell the stock.