TRUST & ESTATE PLANNING

What You Need to Know about Your Equity Compensation

11.18.2021 - John S. Traynor, CFP, CPWA

Equity compensation comes with complex rules and tax implications. You may have questions about what you own, how it works and how it’s taxed. Knowing what you own will give you greater clarity around how much your equity compensation is worth and how it fits into your overall financial plan.    

Equity compensation and incentives generally fall into five categories:

1. Incentive stock option grants (ISOs)

These are a grant or award given to you by your employer to buy company stock at a predetermined or “exercise price.” You can exercise your options when you meet your company’s vesting schedule or holding requirements. You still need to purchase the stock at that time, often at a lower price. If you do not have the funds to exercise your shares, often employers will facilitate a “same day exercise” also referred to as a “cashless exercise.”  This type of transaction allows you to buy and sell the stock immediately so the sale proceeds can be used to cover the cost of the shares. In this situation a brokerage firm would lend you the funds using a short-term loan to cover the cost of exercising.

How ISOs are taxed

If you exercise your shares and sell them immediately, gains will be treated as ordinary income. However, if you can afford to purchase the shares and can hold onto them long enough, ISOs can be advantageous for tax purposes. But there are rules: first, you must wait two years after you receive your stock options before you exercise them; and, once you exercise your options, you must hold the stock for another year. If you meet this timetable, your entire gain (the difference between the exercise price and the market price on the day you sell) will be taxed as a long-term capital gain rather than as ordinary income. This can mean a significant savings since long-term capital gains rates are significantly lower than ordinary income tax rates. 

The IRS limits the maximum value of ISOs that holders can exercise. No more than $100K in stock (valued at the time of grant) may become exercisable for the first time in any one year subject to the companies vesting. Any amount exercised above the $100K limit will be taxed at ordinary income tax rates.

It’s important that you don’t wait too long, as stock options have an expiration date. If you don’t exercise your options before they expire, you lose the benefit of the exercise price altogether.

2. Nonqualified stock option grants (NSOs)

NSOs are similar to ISOs as they allow you to buy company stock at a predetermined or exercise price. You can exercise your options when you meet your company’s vesting schedule. NSOs, however, do not provide the potential tax benefits of ISOs.

How NSOs are taxed

You will pay ordinary income taxes on the difference between the exercise price and the market price when you exercise the options. This amount is reported even if you don’t sell your shares and don’t actually realize that gain. Your company will likely withhold taxes for you if you are a full-time employee. If you are no longer an employee at the firm, you will receive a 1099 and will need to pay taxes on your own. When you eventually sell the shares, any appreciation above the exercise price will be subject to either short or long-term capital gains tax, depending on how long you held the stock.

3. Restricted stock grants

This is company stock that is granted by your company, usually as part of a bonus or additional compensation. Restricted stock is usually subject to a vesting schedule so you will receive your shares in increments, usually over several years. In some circumstances, you may have shareholder voting rights or even receive dividends on the shares before they vest. Any unvested stock is subject to forfeiture if you leave the company before the shares vest.

How restricted stock grants are taxed

Restricted stock shares are treated as income in the tax year they vest, and you will pay income tax on whatever the market value of the stock is on the day it vested. When you sell your shares, you will pay capital gains tax on the appreciation at either the short- or long-term rate, depending on how long you held your shares.  

4. Restricted stock unit grants (RSUs)

RSUs give you the right to own company stock when you meet certain vesting requirements. But RSUs are not actual stock in the company as is the case with restricted stock. You can think of RSUs like a promise to give you a specific number of shares in the future when they vest. Unlike restricted stock awards, RSUs typically do not offer shareholder voting rights or dividends unless your company’s plan allows them. Because of the flexibility RSUs give employers, RSUs are more commonly used than restricted stock awards. 

How RSUs are taxed

Just like restricted stock, RSUs are treated as income in the tax year they vest, and you will pay income tax on whatever the market value of the stock is on the day it vested. Any gains beyond that will be treated as capital gains and taxed at either the short- or long-term rate when you sell, depending on how long you held the stock.

5. Employee Stock Purchase Plans (ESPP)

These plans are voluntary and are often offered by employers and allow you to purchase company stock at a discounted price (i.e., many plans offer a discount of 15% using a “look back” provison). Employees usually use payroll deductions accumulated over a purchase period of one, three, six, twelve, or more months to acquire stock from the company, often at a discount or at least without commission. Most employers offer a window of time where employees can elect this option. There is an IRS cap of $25,000 per year for investments in ESPPs.

How ESPP shares are taxed

Stock purchased through employee stock purchase plans usually comes with favorable tax treatment similar to incentive stock option grants. If you hold the position at least two years after the sign-up window and over one year from purchase, the sale is considered a qualified disposition and a portion of your gains will be subject to long-term capital gains vs. ordinary income tax.

How Your Awards Are Held

Usually, your incentive awards will be held in a brokerage account established by your company that’s in your name. You generally cannot transfer unvested shares or options from this employer-sponsored account until they vest. Once your shares or options vest or if you bought them outright through your company’s stock purchase plan, you can usually transfer your shares to any other provider.

Putting the pieces in place

Understand what you own today, what you may own in the future and the associated tax consequences can help you make smarter planning decisions in context of your overall wealth. This knowledge can put you in a better position to make tax decisions, manage your investment risk and potential gains and plan for your short-term and long-term liquidity needs.

 

 




This communication is intended solely to provide general information. The information and opinions stated may change without notice. The information and opinions do not represent a complete analysis of every material fact. Statements of fact have been obtained from sources deemed reliable, but no representation is made as to their completeness or accuracy. The opinions expressed are not intended as individual investment, tax or estate planning advice or as a recommendation of any particular security, strategy or investment product. Please consult your personal advisor to determine whether this information may be appropriate for you. This information is provided solely for insight into our general management philosophy and process. Historical performance does not guarantee future results and results may differ over future time periods.

IRS Circular 230 Notice: Pursuant to relevant U.S. Treasury regulations, we inform you that any tax advice contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein. You should seek advice based on your particular circumstances from your tax advisor.

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