CEP Client Advisory Services 3 — Questions and Answers
Question 1: An executive holds vested NQSOs and is concerned about a potential stock price decline. Which strategy directly hedges the downside risk of the option position before exercise?
- Exercising and immediately selling the shares
- Purchasing put options on the company's stock (Correct answer)
- Electing a stock swap exercise
- Enrolling in the company's ESPP
Correct answer: Purchasing put options on the company's stock
Purchasing put options on the company's stock directly hedges downside risk by giving the holder the right to sell at a set price, protecting against a price decline.
Question 2: Under what circumstance would a participant's ISO exercise trigger 'disqualifying disposition' treatment?
- The participant sells shares acquired via ISO exercise less than 2 years from grant date or less than 1 year from exercise date (Correct answer)
- The participant exercises ISOs during a company blackout period
- The participant exercises more than $100,000 worth of ISOs in a single calendar year
- The participant files a Section 83(b) election within 30 days of exercise
Correct answer: The participant sells shares acquired via ISO exercise less than 2 years from grant date or less than 1 year from exercise date
A disqualifying disposition occurs when ISO shares are sold before meeting both holding periods: 2 years from grant date and 1 year from exercise date.
Question 3: A client wants to gift appreciated company stock to a donor-advised fund (DAF) to maximize tax efficiency. Which outcome correctly describes this strategy?
- The client recognizes capital gains on the appreciation and claims a charitable deduction for the sale proceeds
- The client avoids capital gains tax on appreciation and receives a charitable deduction for the full fair market value at the time of the gift (Correct answer)
- The client can only deduct the cost basis of the shares donated to the DAF
- The DAF must hold the shares for one year before selling to avoid triggering capital gains for the donor
Correct answer: The client avoids capital gains tax on appreciation and receives a charitable deduction for the full fair market value at the time of the gift
Donating appreciated stock directly to a DAF allows the donor to avoid capital gains on the appreciation and claim a deduction for the full fair market value, subject to AGI limitations.
Question 4: Which of the following best describes a 'net exercise' (or net share settlement) for stock options?
- The participant receives shares net of those withheld by the company to cover both exercise price and taxes (Correct answer)
- The participant sells a portion of shares to cover taxes only, keeping all remaining shares
- The participant pays the full exercise price in cash and receives all shares, then decides how many to sell
- The participant uses vested RSU shares to cover the NQSO exercise price
Correct answer: The participant receives shares net of those withheld by the company to cover both exercise price and taxes
In a net exercise, the company withholds shares sufficient to cover both the exercise price and applicable taxes, and delivers only the net shares to the participant.
Question 5: A departing employee holds both vested NQSOs and vested ISOs. Their separation agreement provides a 90-day post-termination exercise window. After 90 days, what happens to any unexercised ISOs?
- They convert to NQSOs automatically and can be exercised indefinitely
- They expire and are forfeited with no value (Correct answer)
- They convert to NQSOs if exercised within 3 years of termination
- They remain ISOs but can only be exercised during open trading windows
Correct answer: They expire and are forfeited with no value
Unexercised ISOs that are not exercised within 90 days of termination expire and are forfeited per the plan terms; they do not automatically convert to NQSOs.
Question 6: When advising a concentrated equity position holder on diversification, which risk is MOST unique to concentration in a single employer's stock?
- Inflation risk eroding purchasing power
- Idiosyncratic (company-specific) risk that cannot be diversified away (Correct answer)
- Interest rate risk affecting the stock's discount rate
- Currency risk for domestically traded shares
Correct answer: Idiosyncratic (company-specific) risk that cannot be diversified away
Idiosyncratic risk is company-specific and cannot be eliminated through diversification; holding a concentrated position in one employer's stock exposes the employee to both employment and investment risk simultaneously.
Question 7: A participant in a Section 423 ESPP purchases shares at a 15% discount and sells them immediately after purchase. This results in a:
- Qualifying disposition with long-term capital gain treatment on the discount
- Disqualifying disposition with the discount taxed as ordinary income (Correct answer)
- Tax-free transaction because the shares were purchased through a qualified plan
- Short-term capital loss equal to the transaction costs
Correct answer: Disqualifying disposition with the discount taxed as ordinary income
Selling immediately after purchase is a disqualifying disposition; the 15% discount is taxed as ordinary income, and any additional gain or loss is a short-term capital gain or loss.
CEP Client Advisory Services 3
An executive holds vested NQSOs and is concerned about a potential stock price decline.
Which strategy directly hedges the downside risk of the option position before exercise?