Publicly traded and private companies may compensate employees in many ways outside of traditional wages. Depending on an employee’s role, it is common for mid-to-high-level executives to receive company stock as a component of compensation. This helps to align incentives and give employees a share in the upside of stock performance.
Equity compensation comes in many forms, each with their own potential upsides (and pitfalls). Every form of equity has its own set of rules which can include vesting schedules, both income and capital gains taxes, insider trading restrictions and even performance incentives. Getting the most out of your company equity requires understanding key concepts and comprehensive planning.
If you’re new to equity compensation, you might feel overwhelmed with new terminologies, tax codes, and the overall implications concerning your long-term financial goals. You’re not alone. In fact, a vast majority of employees report that they wish their employer would provide them with more education about equity compensation. A similar number of employees report feeling more comfortable with equity compensation concepts when they’re under the guidance of a trusted financial advisor.
In this guide, we will review issues that may arise from equity compensation and discuss strategies to utilize. Prior to making any decisions, we urge employees that receive equity compensation to consult with a tax and financial planning professional to discuss what strategies are available to potentially lower taxes and risk.
This guide was produced under the U.S. tax code effective on September 27th, 2021. Changes in tax laws will be reflected in future updates.
Restricted stock is company stock granted to you that is subject to certain restrictions until the vesting date. In most cases, shares cannot be sold or transferred until after the vesting date. Vesting can be time-based, performance-based, or a combination of both. Typically, if you leave the company before the vesting conditions are met, you will not receive any shares.
Vesting typically occurs in two different ways. Under a graded vesting schedule, shares vest incrementally at regular intervals throughout the vesting period. Under a cliff vesting schedule, all shares vest at the same time at the end of the vesting period.
You become the owner of restricted stock at the time it’s granted, but the shares are held in escrow until they vest. That means with restricted stock, you’ll be able to enjoy the benefits of voting rights and dividends (if the company pays dividends). You’ll also have the benefit of electing to be taxed on the value of the stock at the grant date.1
By default, you aren’t taxed on your restricted stock shares when they’re granted due to the possibility that the shares never vest in the future (called substantial risk of forfeiture by the IRS). Instead, you’re taxed on the fair market value of the shares at the time of vesting. If you sell the shares down the road, you’ll pay the capital gains tax on the sale price minus whatever taxes you paid on the vesting date.
However, with restricted stock awards, you have the option to pay taxes at the time the shares are granted when you make an 83(b) election. If you are willing to take the risk and chance that your restricted stock shares will appreciate significantly before their vesting date, this gives you the opportunity to pay income taxes on the lower price at grant date.
To file an 83(b) election, you must send a letter to the Internal Revenue Service that explicitly states your desire to be taxed on the date the stock was granted, rather than the scheduled vesting date(s). To ensure you don’t miss the filing deadline, you must make your request within 30 days of the grant date.
Equity Compensation Facts
- 37% of employees cited equity compensation as a main reason that they accepted their current job
- 51% of employees say they plan to use equity compensation to help finance their retirement. Other uses for equity compensation are to pay off debt or finance their children’s education.
- Equity compensation makes up for 32% of employee net worth on average.
(Statistics as per Charles Schwab Equity Compensation Plan Participant Survey from October 2020)
1 IRS Tax Code 83(b). https://www.irs.gov/pub/irs-drop/rp-12-29.pdf
Restricted Stock Units
Restricted stock and restricted stock units (RSUs) might sound the same but in practice they have some key differences you should be aware of.
At the time RSUs are granted, you do not actually receive any shares. Think of RSUs as more of a promise to issue shares at a future date (the vesting date). For you, this means that until your RSUs vest, you miss out on the benefits given to employees with restricted stock, such as shareholder voting rights and dividend payouts. In recent years however, some companies have started making dividend-like payments to employees with RSUs.
Restricted Stock & RSU Planning
- Goals and planning. Your restricted stock or RSU plan represents a very real future financial outcome that can affect your income, tax situation, and investment picture. Maximizing the upside of your newly acquired equity involves having financial goals in place, knowing what to expect from your shares and vesting schedule, and understanding how each possible action will impact your future income and tax situation.
- Know your vesting schedule. Knowing when your shares will vest (and, in turn, when you’ll be taxed on those shares) is important to maintain a complete financial strategy. Vesting schedules can be time-based, performance-based, or a combination of both. Meet with your financial advisor and discuss what your vesting schedule means for the rest of your financial picture.
- Consider your taxation options. With restricted stock (and not RSUs) you have the option of making an 83(b) election within 30 days of the grant date. If you’re reasonably sure you’ll remain with the company and meet all vesting requirements and you’re confident your company’s share price will appreciate during that timeframe, paying taxes at grant date could result in significant tax savings.
- Understand the relationship between income and taxes. Whether you opt for an 83(b) election or wait until your shares vest, you will end up with more taxable income. This could easily move you into a higher marginal tax bracket, which could increase your total taxes and create extra work for you to avoid tax penalties. Consult with your financial advisor or accountant to determine if you need to make any estimated tax payments.
- Plan how your portfolio will look after vesting. The balance of your investment portfolio will inevitably shift immediately after your shares vest. As soon as the shares are yours, your options expand from holding all your shares to selling some shares to pay your increased income taxes to completely rebalancing your investment portfolio. Another thing to keep in mind are any restrictions on share sales you may need to adhere to immediately after the vesting date such as blackout periods after earnings are announced.
Non-Qualified Stock Options
Non-qualified stock options (NQSOs) are the right to buy company stock at a fixed price over a given period of time after certain vesting conditions are met. The fixed purchase price of the stock is known as the exercise price or strike price.
Typically, vesting is tied to you staying with the company for a specified duration. If you leave your company before the options vest, you will typically forfeit the rights to those options.
As soon as the options vest, you have the ability to exercise the option. Most companies will specify a grant term under the equity compensation plan which provides a window in which you must purchase or forfeit the shares.
The exercise spread on NQSOs is taxed as ordinary income. For example, if you exercise your option and purchase 1,000 shares currently valued at $11 with a $9 strike price, you would be taxed on $2,000. The taxes may be withheld by your employer. When you sell the shares, the gain is taxed as short term or long term capital gains depending on the holding period after exercise.
In most cases, you’ll use a cashless exercise when you exercise your options. A cashless exercise is an “exercise-and-sell” transaction, meaning you’ll immediately sell your shares upon exercising and use the proceeds to cover the exercise price, tax withholdings and any applicable broker fees.
- Goals and planning. Every successful financial plan begins with smart goal-setting. Begin with the end in mind: what would you like to do with the money you receive when you eventually sell your shares? Having a tangible outcome to work toward will help you stay the course and make sound, long-term financial decisions.
- Educate yourself on stock option arithmetic. When it comes time to exercise your options, do your best to get an accurate picture of your true profits. Consider the strike price and any taxes your employer withholds to get an idea of how much value your shares truly add to your portfolio. Knowing this before you take action will help inform you on whether or not to exercise now or later.
- Patience pays off. Stock options commonly have a 10-year exercise window. If you believe in your company and have the ability to take the risk, it might be in your best interest to wait additional time before you exercise your options.
- But don’t be afraid to act quickly. In your circumstances, it might make more sense to exercise your options as soon as you can. If your shares represent a significant portion of your net worth, for example, selling immediately and rebalancing could be a prudent move. Likewise, if your company is known for its volatile share prices, cashing out and reinvesting in a more stable set of securities might be the best option.
- Understand the relationship between income and taxes. When you exercise your options, you will end up with more taxable income. This could easily move you into a higher marginal tax bracket, which could create extra work for you to avoid tax penalties. Consult with your financial advisor or accountant to determine if you need to make any estimated tax payments.
Incentive Stock Options (ISOs)
Incentive Stock Options (ISOs) are similar to NQSOs. One key difference is their potentially more favorable tax treatment upon exercise and sale.
Unlike NQSOs, ISOs are not taxed when you exercise them. In fact, if you hold onto the stock for more than one year after exercise and two years after the grant date, any gains above the strike price will be taxed at the more favorable long term capital gains rate. If you sell the stock less than one year after exercise, the option will be taxed as if it were an NQSO.
ISOs and Alternative Minimum Tax
While ISOs are taxed at a lower rate, they can impact owners that pay the Alternative Minimum Tax (AMT). The AMT is a separate tax liability that uses tax preference items to determine taxable income. Individuals must pay the AMT liability if it is greater than their regular-tax liability.
ISOs are considered tax preference items. If you hold ISOs, exercising your options has no impact for regular federal income tax purposes. The spread between the ISO purchase price and grant price is considered income for AMT purposes.
Certain individuals don’t have to pay the AMT if their total AMT liability is lower than the AMT exemption amount. In 2021 the exemption is $73,600 for individuals and $114,600 for married couples. The exemption phase out starts at $523,600 in Alternative Minimum Taxable Income for individuals and $1,047,200 for married couples.
Planning for ISOs involves two major questions:
- When should the options be exercised?
- Does it make sense to hold onto the stock for more than one year in order to potentially pay fewer taxes on gains?
Your tax situation, net worth, and other individual circumstances can impact what decisions to make for ISOs. If the option/stock represents a large portion of your net worth, it may make sense to sell immediately upon exercise. This can help diversify the risk associated with a concentrated stock position. Risk is compounded by the fact that your earnings and savings are tied to the health of one company.
If the stock represents less than 10% of your net worth, you may be able to accept the risk associated with holding the stock for over one year.
Note that it is possible that over that time period, the market value of the stock can drop below the strike price or amount that one paid for it.
Equity Compensation at Pre-IPO Companies
Receiving equity compensation such as stock options or RSUs at a startup or pre-IPO company can lead to a difficult and uncertain planning situation. The first factor to consider is that pre IPO shares inherently face liquidity challenges, and you may have difficulty (or find it impossible to) find a market to sell the shares. In many cases, you must wait for a company liquidity event to sell them. You also have to be aware of lock-up periods where you cannot sell and be mindful of any applicable security laws.
In addition to liquidity issues, you face the very real prospect of the dilution of your shares’ value. Pre-IPO companies often go through several rounds of funding from investors, which means your 5% ownership could look more like 0.5% by the time the next liquidity event arrives.
Pre-IPO Tax Deferral Opportunity
The other is that, until the Tax Cuts and Jobs Act of 2017, these shares were taxed in the exact same manner as they were in publicly traded companies. The Tax Cuts and Jobs Act allows you to defer the income (and tax liability) you receive when non-qualified stock options are exercised or when restricted stock units vest for up to five years. Social Security, Medicare, as well as state and local taxes are not deferred and you’ll have to withhold them at the exercise date.
To take advantage of the tax deferral, you must complete and submit a Section 83(i) election form within 30 days of receiving either restricted stock units or non-qualified stock options.
Stock Appreciation Rights
Stock appreciation rights (SARs) are a different type of equity compensation that allows you to receive the appreciation in a company’s stock value as opposed to actually being awarded company shares.
If a company’s stock was valued at $15 per share in the market on the date the SAR was granted and the market value increased to $25 per share on the day the SAR was exercised, you would receive $10 per share. When the SAR is exercised, you can either receive cash or company stock equivalent to the value of the total appreciation. The value of the cash or stock you received would then be taxed as ordinary income in addition to FICA taxes.
Unlike restricted stock, employees with a SAR do not receive voting rights or dividends. And unlike stock options, you do not need to put down any cash upfront (as you might have to in order to exercise both NQSOs and ISOs).
If you received company stock for exercising their SAR, you will be subject to capital gains taxes whenever you sell those shares in the future.
For employees and executives who receive equity compensation, it’s natural to have concerns about complying with any company-specific trading policies. 10b5-1 plans can help shield you from potential liability or allegations in the future.
A 10b5-1 plan is a drafted document that details how you will sell your equity compensation shares in the future. You can specify the amount of shares you’d like to buy or sell, the price points you want to buy or sell at specified dates.
According to the SEC, if you draft your 10b5-1 plan prior to receiving any inside information about your company, it is likely you will be shielded from any liability concerning insider trading over the entire duration of your plan (known as affirmative defense).
While having a 10b5-1 plan can protect you from liability, there are certain actions you should avoid that can compromise that protection:
- Amending your plan. As established above, you should always adopt your 10b5-1 plan before you obtain any potential inside information about your company. The same rule applies to amending your plan. If you decide to adjust your plan’s parameters, do so at a time when you don’t have any non-public information about your company.
- Cancelling your plan. Canceling your 10b5-1 plan can raise red flags with the SEC, especially if it’s done after you have executed sales or obtained any insider information. Generally, it’s best to stick with your plan for the duration. If you must cancel the plan, do so only when you are not in possession of any non-public information and wait for 30- 60 days before drafting and submitting a new plan.
- Hedging your position. Rule 10b5-1 specifically states that any corresponding hedges made regarding the securities in your plan can lead to the plan losing its affirmative defense status.
Equity Compensation Facts
- 85% of employees wish their employer would provide them with more education about their equity compensation plans.
- 22% of employees say they would like help balancing equity compensation with investments.
- 30% of employees regularly exercise or sell as part of a long-term plan.
- 83% of employees are confident in their ability to make smart decisions about equity compensation with the help of a financial advisor.
(Statistics as per Charles Schwab Equity Compensation Plan Participant Survey from October 2020)
Employee Stock Purchase Plan
An Employee Stock Purchase Plan (ESPP) allows employees to purchase shares of company stock at a potential discount to current fair market value. There are two major types of ESPPs: qualified (which is most common) and non-qualified.
Qualified ESPPs, or 423 plans, allow you to buy up to $25,000 of company stock in a calendar year with a potential discount of up to 15% of fair market value.
423 plans also offer special tax treatments that can be attractive to you. When you buy stock in a 423 plan, you do not report any income until disposition, even if you receive the maximum discount of 15%.
You must meet two conditions to have a qualifying disposition when selling stock in a 423 plan:
- No sale may occur within two years from the grant date of the shares.
- No shares are sold within one year of actually receiving the stock.
If both of these parameters are satisfied, you will only pay ordinary income taxes on the discount offered assuming that the purchase price is less than 100% of the fair market value of the shares on the purchase date. The difference between the actual un-discounted market price at offering and the market value at sale will be considered a long-term capital gain for tax purposes and be taxed more favorably.
If those parameters are not met, you will lose the tax benefit associated with a qualified ESPP.
Due to the complex nature of how qualified ESPPs are taxed, it is highly recommended that you seek the advice of a tax professional and provide all information required in order to make optimal decisions for tax purposes.
Non-qualified ESPPs do not provide any special tax treatment. Upon receiving shares in a non-qualified ESPP, you will be taxed as compensation on the difference between the fair market value of the shares and the amount paid for them (the discount). From a disposition standpoint, the holding period begins on the date of acquisition while the basis is the amount paid for the shares increased by the compensation reported for taxes (essentially the fair market value of the shares at purchase).
Bringing in a Financial Advisor
Receiving equity compensation can dramatically transform your financial outlook for the better. It can bring you closer to your long-term financial goals and even widen the scope of what you can accomplish in this lifetime. Equity compensation can also create substantial additional legwork if you want to maximize returns and avoid surprise tax penalties.
Trading salary for equity is a balancing act of risk and reward. It means having a stake in your company beyond employment. With those higher stakes comes a higher degree of responsibility and scrutiny on your part. You must become more aware of your projected income and marginal tax rates. In some cases, stock options might run counter to your overall financial strategy. In others, accepting an equity position is advantageous only after some well-thought financial maneuvering.
There is no perfect strategy for incorporating equity compensation into your overall financial plan. The fact is, every individual is unique, with their own circumstances, goals, obligations, and risk tolerance. If seeing how equity compensation fits into your big picture seems overwhelming, that’s because it is.
With the right guidance, you can approach equity compensation in a proactive, informed way that brings you closer to your goals. At Wealthstream, we look at your entire financial present and future. We consider your retirement plans, your personal and family goals, your age, your income and your career trajectory to create a plan that maximizes your potential returns.
Our advisors intuitively understand the ever-changing nature of financial markets and tax laws. Our financial plans are flexible by design, built to both take advantage of and guard assets from new tax regulations.
To start building a financial plan that will allow you to maximize the potential of your equity compensation, retirement, investments, and more, speak to a Wealthstream financial advisor today.
Bargain Element – The difference between the market price and exercise price of stock options. This can be referred to as the gain on one’s equity compensation.
Capital Gain Tax – Tax imposed on the sale of capital assets in which there is a realized gain. Assets that were held for greater than one year and sold at a gain are typically taxed at the more favorable long-term capital gains tax rate.
Exercising – The purchase of the stock in an underlying option is referred to as exercising. Most companies allow what is called a “cashless exercise” if stock is sold immediately after exercising. This eliminates the need of having to purchase stock with cash prior to selling.
Exercise Window –The period during which one can buy shares at the agreed upon price in a stock option.
Grant Date – The date on which an employee receives a form of equity compensation.
In-the-money vs. Out-of-the-money – In-the-money refers to stock options that have a market price greater than the strike price. This refers to options that have a dollar value. Out-of-the-money options have a higher strike price than market price and indicate options that are currently deemed worthless.
Ordinary Income Tax – Tax typically imposed on wages, salaries, bonuses, etc. These sources of income are taxed at one’s marginal tax rates.
Strike Price – The price at which a stock can be purchased in an underlying option. The strike price is agreed upon in advance in the stock option agreement.
Vesting – Vesting occurs when a non-forfeitable transfer of money or stock is obtained by the employee. Companies typically use a graduated vesting schedule (installments over time) or cliff vesting (when all stock vests after a certain date).
Disclosure:Wealthstream Advisors, Inc. (“Wealthstream”) is a registered investment adviser with its principal place of business in the State of New York. Additional information, including management fees and expenses, is provided on our Form ADV Part 2 available upon request or at the SEC’s Investment Adviser Public Disclosure website, here. Past performance is not a guarantee of future results.
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investors. Information presented herein is subject to change without notice and should not be considered as a solicitation to buy or sell any security. This report may not be construed as investment advice and does not give investment recommendations. Any opinion included in this report constitutes our judgment as of the date of this report and are subject to change without notice.