Author: Sara Gardner, CFP®
You received a grant for your company stock as part of your benefit package now if you could get the secret decoder ring at the bottom of the box to answer all your questions on what exactly that means. Same as investing, stock options are not a guarantee; you could have the winner or the dud. The timing of when to buy and sell, combined with taxation depends on several variables.
When prospects or clients come to me their concern first starts with the risk of concentration in the company. They are on payroll and now, they have the value of the stock wrapped up in the company as well, this is more amplified if they are the sole income earner.
For this reason and the studies that buying and holding a single stock leaves risk on the table and may not be a benefit in this situation. Due to this I will focus on explaining the benefits and divesting of the stock benefit in a tax efficient manner.
Bringing on the right team to help illuminate your options can help for your specific goals, so you do not pay Uncle Sam more than required, and capitalize the benefit that align with your financial goals.
Here is a quick and dirty breakdown of executive benefits and what to consider.
Let us look at some key dates and terms before looking at the options.
The 83(b) election, due within 30 days of grant, notifies the IRS of your decision to be taxed on the date the equity was granted versus the date it vests. The selection is made if you believe the stock price will continue to go up and to start the holding time period clock to receive long term capital gain treatment, currently 15% or 20%, over ordinary income of Federal Income tax rates currently up to 37%.
If you do not elect your 83(b) election, the withholding will be applicable at vesting. Deciding on which election to make depends on several factors, including where you believe the stock is headed… up or down.
Be aware the required withholding may not cover your full tax obligation.
Exercising Your Employee Stock Options
When looking at your options, timing and the rules of buying, selling and withholding can vary by type of the grants. Your company could be private, ready to go public (pre-IPO), or already public. Let us look at the timing of exercising your right to buy your company’s stock.
Some options you have may need to be exercised. The exercise price, also known as strike price, this is the price at which you have the options to purchase a given number of shares, determined by the Fair Market Value (FMV) at the time the options are granted. You will pay the exercise price multiplied by the number of vested options you wish to exercise. The taxes you pay will be determined on the difference, or spread, between FMV and your strike price.
A Hypothetical Example to Illustrate Exercising Stock Options:
You have 1,000 vested options with a strike price of $1; the FMV is $2.
To exercise you will need to pay $1,000 and your taxable gain will be $1,000 at exercise. *Depending on the options you were granted your gain will be taxed differently.
If your strike price is low, it may make sense to exercise early for the cost savings and not owe much in taxes. A general rule of thumb is not to spend more than 10% of your net worth on exercising. When considering exercising with pre-IPO, when the stock price is marginally above your strike price and you are certain your employer is going to succeed due to strong earnings going into the IPO, there is consistent growth, and their profit margins are expanding. If the company has a successful launch this will save you in taxes, if not and the company IPO fails you lost the maximum of 10% of your net worth you chose to exercise, plus maybe some Alternative Minimum Tax (AMT) paid.
To take minimum liquidity risk, when your money is tied up without being able to sell, exercise when your company tells you it has filed for an IPO. In general, expect a year before you can sell the stock due to the official IPO launch and the 6-month employee blackout period right after the IPO where you will be restricted from selling the stock. For publicly traded companies you may also have a blackout period, known as Rule 144, prior to earnings announcements to protect against insider trading, in addition, you may be required to receive pre-trade clearance before selling your stock position, including possible limitation on how much you are able to sell and the window within which to place the trade. By exercising this also starts the clock for long Term Capital Gains treatment which requires holding the stock over 12 months.
Exercising Your Stock Options Post-IPO
But wait, there are benefits of waiting after your company goes public or currently public because you know the actual trading price of the stock. If your exercise price is at or above the current trading price it is probably best to hold off on the exercise as you will be “out the money”, meaning your options have a negative value. Conversely, if your exercise price is below the current trading price you are “in the money”, or your options have a positive value, and you should review if the timing is right to exercise. Then determine which cashless transaction strategies below may make sense for your personal tax situation.
The Taxes and Costs to Exercising Stock Options
You may be surprised to learn the costs to exercise your options and even more so with the taxes related to exercising. Each option has its own timeline on when to exercise, sell and different tax structure so should be looked at individually by type. You can consider a cashless transaction; the most common is to use the shares themselves to pay the withholding where the shares are withheld.
Closely related is selling the shares to cover your tax obligation resulting in the same net amount received so long as there are no fees or commissions from the stock sale.
If you are positive on the stock and want to maintain all shares from your option you may have the alternative of paying the mandatory tax withholding (25%, or 35% if you exceed $1M for restricted stock) in your personal cash reserves, should you have enough.
There are also option fund lenders that offer loans in order to pay for the cost to exercise and taxes; however, it is worth noting the costs for the service may eliminate them from consideration.
Types of Stock Options
Let me breakdown the specific grants below for further clarity given the award you received.
The tax is determined based on the FMV when they vest, depending on your 83(b) election. These options are treated as ordinary income (similar to a bonus) and subject to income tax withholding, including payroll taxes of Medicare and social security withholding. Due to this your RSU income and withholding is reflected on your W2. In addition, you may be subject to short or long-term capital gains when you sell the stock.
There is typically very little tax benefit to hold onto RSUs after they vest, it is generally recommended to sell after vesting. If you leave before your RSUs are vested, the outcome is the same as with unvested employer contributions in a 401K, you will forfeit the benefit.
At exercise, however, Alternative Minimum Tax (AMT) may come into play. The difference between the exercise price and the FMV of the stock on the day of exercise is known as the bargain element that is an adjustment for AMT (28%) purposes and can prove a costly phantom tax since you may pay tax even though you have not sold the stock, you may be able to recoup AMT paid through a minimum tax credit when you later sell the shares.
The tax obligation is determined when you sell and based on timing. Starting with the grant date, you will typically exercise/ buy the stock a year later to start the time period clock on holding the stock.
By waiting another 12 months before selling you will be taxed at the more favorable long term capital gains rate, known as a qualifying disposition; this equates to a total of 2 years from grant so long as you exercised more than a year prior to the sale of the stock.
If you sell prior to the 12 months after exercising, a disqualifying disposition, subject to the higher tax of short-term capital gains, assuming a gain.
It is worth mentioning these must be exercised during employment, prior to expiration, or within 90 days of your last date of employment.
The bargain element, spread, referenced in ISO above is taxable compensation with NQs versus subject to AMT as with ISOs.
At the time of exercise, you will be subject to income, Medicare and Social security withholdings similar to a bonus or RSU at vesting and will be reflected on your W2, similar to RSU. Holding the stock after exercise exceeding 12 months the growth will be subject to long term capital gains rates, if held less than 12 months the gains will be subject to short term capital gains rates.
Check with your company’s policy, you may be able to delay exercising NQs after the 90 Day separation window that you are subject to with ISOs.
There may be an associated vesting schedule, or they may vest at the end of the performance period, once the requirements are met you own the shares and cannot be forfeited.
If you do not meet the requirements before the end of the performance period, your award may be forfeited.
Valuing the award is calculated by reviewing the previous day’s closing price and multiplying by the total number of awarded shares, this differs from the FMV used for the Federal tax calculation. The award specifies the FMV and is used to determine the compensation income. The FMV price can be prior business days close, the average high-low for the day, current day’s close, or the real-time price.
You will not be taxed at the time of grant; you will be taxed as compensation at vesting with applicable payroll tax withholding.
RSUs and PSUs are similar, you may have options on how you pay the mandatory withholding, the 83(b) election, review the plan rules to see your options and the percentage of withholding required. The amount of income subject to Federal tax is calculated by taking the FMV of the grant at vesting (or grant with 83(b) election) multiplied by the shares. The income and withholding are reported on your W2. Vesting starts the time clock for determining short- or long-term capital gains if you do not sell the stock at vesting.
The award provides you with the ability to profit from the increase of the company stock based on a set number of shares over a specified period, they can also be issued with other options of ISOs or NQs, allowing you to choose which to exercise the option or the SAR, not both.
With SARs you benefit from the increase in stock above the price specified in the award, but an advantage over other options is you are not required pay the exercise price, buying the stock, instead you receive the net amount of the increase in either cash, stock, or a combination; determined by what is specified in the award agreement.
Since you are not purchasing the stock, SARs are less preferred for the company’s seeking revenue as they are not necessarily a revenue generator for the company. Still, other employers prefer using SARs to offer the benefit to their employees while not diluting the company stock. SARs are like NQ stock options with a set price at grant, generally they have both a vesting period and an expiration date.
At exercise you will recognize your compensation income on the FMV on the amount received at vesting, with the obligatory income withholding from the cash or received shares, reported on your W2. You are also able to exercise any time prior to expiration with the time clock starting at expiration for determining capital gains treatment. When leaving your company your expiration date may be accelerated for your vested, non-exercised shares.
To determine the impact of your award, refer to the agreement.
You are still subject to the applicable social security and Medicare taxes in the year the income is earned. With the agreement to recognize the Federal and state ordinary income in a future year(s), after retiring, or another time-based triggering event, such as 5-, 10-year or more years until distribution. Many plans allow you to change the deferral amounts 12 months prior to payout, but the new distribution date must exceed the original payout date by 5 years, there is a 20% excise tax and penalty from the date of vesting if you do not adhere to this. This gives you the flexibility to schedule the distributions to coordinate with the timing of funding for your specific goals such as retirement income or your children’s or grandchildren’s education, or distributions based on the tax implications. Participating in this plan is normally advisable after you have already maximized your 401K or qualified versions of tax deferral options. NQDC plans come with the benefits of tax-deferred growth, but have inherit risks, including loss of the assets. The distributions are not rollover eligible into a qualified plan such as an IRA or 401K to further defer your taxable income. You should also know that, unlike company’s contributions to your 401K, the NQDC plan are still considered as part of the employer’s assets as a promise to distribute based on the specified schedule. The assets are typically held in a trust, usually a Rabbi Trust, to pay your future benefits but subject to loss from being subject to creditors’ claims in a corporate bankruptcy situation. For these reasons and more you should consider if participating in the NQDC makes sense for your specific situation.
As an example, you can be granted 5% non-voting interest initially with an immediate or deferred vesting schedule, potentially receiving additional interest after a set amount of time following the subsequent vesting schedule and subject to forfeiture restrictions. Like SARs, the Phantom stock can be granted as appreciation, to preserve the dilution of the company’s stock ownership or it can be issued as a full value award that pays the full value of the stock as well as the appreciation.
The value of the award can be complicated as to what is included for the company valuation and if specific divisions of the company are to be excluded, or a reduction taken for capital investments from shareholders, any dividends paid, etc. The valuation is not pegged and can fluctuate from year to year based on the valuation of the company reviewed during specified triggering events specified in the plan.
Similar to NQs, phantom stock plans have a substantial risk of forfeiture until it is actually paid to you. Interestingly, although it is phantom, it can still pay dividends and still subject to price fluctuations of the issued stock and the associated taxation, but it can also be changed at the company’s discretion.
The phantom stock can be paid out in a lump sum or in installments and considered compensation at the time it is vested, paid, and subject to income withholding. The income and withholding reflected on your W2.
There may be other fringe benefits and benefits to consider, this is not a comprehensive list accounting of all that is available. However, what I want you to do is NOT get sucked into the market noise surrounding the chatter of the stock, especially when you are in your blackout period when you are not able to do anything about it. You cannot time the market, the same is true with the timing of selling your stock. Review the risk of holding a concentrated position, considered more than 10% of your investable assets, along with the tax implications I reviewed, in addition to the Medicare surtax of 3.8% on the net investment income (NII) if you exceed the threshold amounts that should be considered. When you become aware of your option grant or award, it will be a good time to have a team in place to develop strategy(ies) specific to you.
Because of the complexity of owning and exercising employee stock options, many decide to reach out to a financial advisor or an accountant. Here are a few questions to help you evaluate your advisors
The key is to let the benefits of stock options work for you, do not let the complication distract from what you want in life. Having a good financial advisor and an experienced CPA can help educate you on your options, organize your finances and develop financial, investment, and tax plans that align with your goals in life. Developing a plan puts you in control of your money, instead of your money controlling you.
EP Wealth Advisors (“EPWA”) makes no representations or warranties as to the accuracy, timeliness, suitability, completeness, or relevance of any information presented in this report. EPWA has used its best efforts to verify the data included in this report. The information presented was obtained from sources deemed to be reliable. However, EPWA cannot guarantee the accuracy or completeness of the information offered. Information presented is general in nature and should not be viewed as a comprehensive analysis of the topics discussed. It is intended to serve as a tool containing general information that should assist you in the development of subsequent discussions. The content of this blog is intended to be educational in nature. It should not be construed as investment advice and is not intended to supplement professional advice. Always consult a financial professional, attorney and/or tax professional prior to implementing anything referenced directly or indirectly herein. EP Wealth Advisors is not in the business of providing comprehensive tax advice.
Sara has been in the finance industry since 1998 working primarily with mutual funds and annuity fields.
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