Equity-based compensation is a wonderful way to potentially share in the profits and appreciation of your company. Getting the most out of your equity compensation requires understanding key concepts, terms, and conditions related to this equity. It is also important to understand the tax implications and to make decisions with a long-term financial plan in mind. Not fully understanding what you have been granted or not having a plan can easily lead to mistakes, lost opportunities, and even outright losses.
In this Insight, we will explore some common mistakes to avoid when seeking to maximize after-tax profits from equity compensation. As always, please consult with a financial advisor before making any investment and planning decisions.
If you are granted compensation in the form of Restricted Stock Awards (RSAs) or stock options, you do not automatically pay taxes on the shares when they are granted because the IRS deems there is a “substantial risk of forfeiture.” In other words, there is the risk that the shares will not vest with any value until certain conditions such as future service requirements or performance benchmarks are met. Therefore, you won’t pay regular taxes, at least until the shares vest. Restricted stock awards and stock options do have differences but the advantages and disadvantages of filing an 83(b) election remain the same. Please see our Insight “Understanding Equity Compensation at Privately Held Companies” for the full breakdown.
If the company allows an 83(b) election on your equity, you have 30 days from the initial grant date to make an extremely important financial decision. Will you choose to pay income tax at the date when shares are granted, or wait until the shares vest?
To examine the tax implications, imagine a scenario where an employee receives 500,000 shares of restricted stock priced at $0.01 per share, for a total current Fair Market Value (FMV) of $5,000. Assume the shares fully vest four years from now, and the stock at that point is trading at $2 per share.
If she files an 83(b) election, she will pay income tax on $5,000. When the shares are worth $2 at the time of vesting, no ordinary income taxes will be due.
If she does not file an 83(b) election, then when they vest in four years, she will pay ordinary income tax on $1,000,000.
Besides the benefit of potentially saving ordinary income taxes by filing an 83(b) election, another benefit is being able to accelerate the beginning of the capital gains tax holding period. If you hold the shares for one year before selling, you are taxed at a more favorable long-term capital gains tax rate. When you take the 83(b) route, your capital gains clock starts from the date of grant instead of the year they vest. This means that if you file an 83(b) election, you could potentially immediately sell your stock at vesting instead of waiting another year after the vesting date to receive long-term capital gains tax treatment.
There are substantial risks to filing an 83b election including:
In either of these cases, you would not receive a tax refund. It is obviously impossible to know for certain whether a share price will go up or down and whether it would be worth it to make an 83(b) election. So how do you decide whether to file an 83(b) election?
You should make this decision based on personal factors such as your appetite for risk and cash flow. If you are just starting your career, you are likely to have more enthusiasm since you have future earnings potential and a long time horizon. Ask yourself, how would you feel if you ended up paying tax on shares that could turn out to be worth less than they are today—or even worthless? What about the initial cash outlay?
Secondly, you should think very hard about how confident you are that the stock price will go up. How much do you know about the company? What kind of track record does the management team have? Does the company have a lot of direct competitors or is it doing something truly unique and desirable? Is there an expectation that the company could go public or be acquired? When could you sell your shares?
Finally, consider applicable tax rates, your tax situation, and your investment goals. How long do you have in the market and what is your required rate of return?
A financial advisor can help you map out when shares might vest and calculate potential taxes. They can show how different assumptions on the underlying price movement of the shares could impact your overall financial planning goals.
Although receiving equity compensation can have significant benefits, you might want to consider selling vested shares quickly and diversifying your position. It may be difficult to do so if you feel deep loyalty to your company and believe the price will continue to rise or there is a large, embedded gain and you want to avoid paying tax. However, it makes sense to sell shares if your net worth is heavily concentrated in your employer’s stock.
There are two further reasons to consider diversifying. First, if you are an executive at the company, you may be granted more shares in the future. Second, equity compensation is often inextricably linked to the health of your company; more profits equal a higher share price. As you receive more shares and the stock price grows, the shares you own become an even larger part of your net worth, leading to greater stock concentration risk. On the flip side, if the market is volatile, or your company is going through a bad period causing the price to drop, you could stand to lose income and capital.
You should be asking yourself: Would a stock decline hurt my ability to buy my dream home, fund college for my children, retire, etc. and am I okay with that risk? We cover this issue in greater depth in our Insight on divesting a concentrated stock position.
There are two main types of stock options, Incentive Stock Options (ISOs) and Non-Qualified Stock options (NSOs). Both are subject to different tax rules. If handled properly, ISOs have certain tax advantages over NSOs. For ISOs, as long as certain holding period requirements are met, only long-term capital gains, not ordinary income tax, is payable when the shares are sold. However, ISOs can incur a different tax at exercise: Alternative Minimum Tax (AMT). This tax is calculated on the “spread” between the FMV of the shares when you exercise options and the exercise or strike price.
To make things even more complicated, when you pay AMT, you receive a tax credit equal to the difference between the regular tax and AMT tax owed. This can be good news as the credit can be used to lower your federal tax liability in future years when no AMT is due.
In order to benefit from this favorable capital gains tax treatment for ISOs, you must sell the shares after holding them a minimum of two years from the grant date and one year from the exercise date or it is considered a “disqualifying disposition.” In a disqualifying disposition, you would need to pay ordinary income tax on the lesser of the spread between the stock's FMV at exercise and the exercise price and or the spread between the stock’s sale price and the exercise price. The difference between the sale price and exercise price would be subject to capital gains tax. A disqualifying disposition would however eliminate your AMT tax liability. This is comparable to how NSOs are taxed except you pay ordinary income tax on the spread between the price at exercise versus the strike price.
While a disqualifying disposition might seem undesirable, there are a number of cases in which it may make sense. For example, maybe you exercised the option when the stock price was much higher, causing a large AMT tax liability and the price is now dramatically falling. It may be better for you to make a disqualifying disposition and trigger ordinary income tax instead of being subject to a larger AMT tax liability. Further, if the stock price on the date of sale is less than the exercise price, then the difference between the sale price and the exercise price will be treated as a capital loss.
Another example of why a disqualifying disposition makes sense is, if the company stock is fluctuating and unpredictable and/or if it has seen a steep rise in value, you will still be able to sell and may make a profit. Even though you may be subject to income tax, at least you will be able to liquidate your position with a certain knowledge of returns without running the risk of the price falling below the exercise price.
There is also the example of wanting to balance your portfolio and reduce your stock concentration risk as noted above and reallocate proceeds into a more balanced asset allocation. Last, perhaps you need additional cash to fulfill your goals of purchasing a home or funding education.
In all these cases, the decision of whether to sell via a disqualifying disposition depends upon your income tax situation and your overall financial goals. The calculations can be complex and should be discussed and reviewed with a financial advisor and accountant.
While the issues highlighted above are some of the most important to consider, they are only a small selection of the potential traps and missed opportunities associated with trying to balance profit, timing, and taxation for equity-based compensation.
A financial advisor will be able to understand your needs and risk tolerance, provide a long-term strategy, and take a holistic view of your portfolio and financial goals. If you’re looking for just the right amount of information to help you work through your situation, don’t hesitate to reach out to us today.