Saturday, November 01, 2014

Analysis of Differential Tax Rate Impacts on Timinig of Exercising SARS

Okay, the title is a bit of a joke, I am sure the quality of this analysis is nowhere near the kind of academic rigor that title suggests. (Heck, it's not even peer-reviewed, so there is always the possibility I am just outright wrong.)

Anyway, the proposition I wanted to evaluate: if one has SARS (Stock-Appreciation Rights) that are significantly above water, is there a benefit to exercising them early, for the sole purpose of ensuring all future gains are taxed as long-term capital gains (LTCG), at a rate of 15% + State? In MN, that would equate to about 22% in the typical case. As opposed to holding them as long as possible, in which case all gains will be taxed as ordinary income (OI), at a rate of 28% + State? Again, in MN that would be about 35%.

To cut to the chase, the answer is an emphatic no, do not sell prematurely for tax considerations!!!

This is what I thought going in. A general rule of investing is that tax considerations should take a back-seat to investment strategy (don't let the tax tail was the investment dog). The reason I had to work this out to convince myself, though, is because of the rate differential. I wanted to see if cashing out at some early point, and thereby subjecting all future returns to the much lower LTCG rate, would offset the benefit of deferring taxation as long as possible by holding to maturity.

I am fairly confident that cashing out early is not optimal, under any scenario, given my reasonable, simplifying assumptions. Those are:
  • No market timing. Uniform rate of return for all years. Obviously this is not what happens real-world, but over a reasonable long time-horizon, it should be a good approximation.
  • Early-exercise proceeds, net of taxes, are immediately reinvested in the same stock (with zero transaction costs).
The model pasted below uses a 6% return on capital, and a 20-year time horizon. For simplicity, it assumes a grant value of $10,000, but any grant value will illustrate the same results. I played with all the parameters, and they affected the relative penalty of early exercise, but never resulted in a scenario where early exercise was optimal.

(A copy of my model is available here.)

So in the scenario above, each row shows the NFV of the investment at 20 years, if it were subject to early exercise at the year denoted in the row. For example, if the initial grant of $10,000 were cashed in at the end of Year 4, and immediately reinvested in the same stock, the value after 20 years would be $3,756. Whereas if held to its 20-year "maturity", the value would be $14,346.

In hindsight, the explanation is blindingly obvious. Before you cash in, you have the entire $10,000 basis working for you. At the point you cash in, you only have whatever you have gained working for you. I think it is a bit analogous to killing the goose that lays the golden eggs, thinking you can invest all those unlaid eggs now, versus taking and investing the eggs as they come.

Concluding thought: The idea of  attempting "market timing"--never a good idea--is wildly inadvisable in the case of SARS (and I think much the same analysis goes for stock options).

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