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Equity Compensation Basics

Investment Equity Compensation Stock Options Tax Building Wealth

Equity Compensation Primer

Restricted Stock Units/Awards: RSUs are a form of (additional) compensation issued by a company to an employee in the form of shares of company stock. They are issued to employees through vesting and distribution schedules (more on those later). Typically they are awarded for the achievement of performance milestones or upon remaining with their employer for a particular length of time. In theory, RSUs enhance employee commitment for the work they perform by giving employees interest in company stock. Thereby the company's success becomes the employees' success (and financial gain). Once the units vest (meaning they become legally owned by the employee) they are assigned a fair market value (FMV). Vesting schedules for RSUs vary, but a common configuration is for an RSU grant to vest over a period of four years, with 25% of the granted shares vesting per year. At vesting, they are also considered ordinary income, and usually, for the convenience of the employees, a portion of the shares are withheld and sold to pay income taxes. 

Tax Considerations for RSUs: RSUs create ordinary income and are taxed like a regular paycheck. This means that they’re subject to federal income tax, Social Security taxes, Medicare, and state/local taxes. You’ll also be expected to pay the taxes upfront upon acceptance. Many employees choose to surrender some shares of the company stock to cover the associated taxes. Some companies sell a portion of the RSUs on behalf of their employees to cover the tax burden right from the award. The employee receives the remaining shares and can sell them immediately, or later at their discretion, and normal capital gains rules will apply based on the timing of the sale.

A few technical jargon words are included here, the links to their Investopedia definitions are provided for additional context. Below I cover four critical events in the lifecycle of ISOs: Grant, Vest, Exercise, Sale

Grant: Stock options are issued, or granted, at a price set by the employer company, called the strike price. 

Vest: When the stock options are granted, they are typically granted with a vesting schedule. Vesting is the right to a future asset (the company stock in this case). It is the process of transferring the right to exercise the options into company shares to the employee over a period of time. Typical vesting schedules are cliff (immediate or 100% after a period of time) and graded vesting (gradual usually over longer periods). A company’s 401(k) matching funds often have a vesting schedule before they become the employee's. 

Exercise: When an employee elects to exercise their options, they are converting the granted shares of the company (possibly at a discounted price). This may be the current share price, or the company can elect to provide a discounted share price. Average discounts range from 5-15%. Once the options are exercised, the employee has the freedom to either sell the stock immediately or wait for a period of time before doing so. Unlike non-statutory options, the offering period for ISOs is always 10 years, after which time the options expire.

Sale: For employees with ISOs, the exercising of shares is NOT a taxable event. Although there can be AMT implications for higher-earning employees. After exercise is complete, the employee may sell at their discretion (and in accordance with any company-imposed blackout dates). To get the preferred tax treatment, ISOs must be held for two years from the date they are granted and at least one year from the exercise date. Otherwise, a “disqualifying disposition” occurs, and the difference between the grant price and market value on the exercise date is subject to ordinary income tax.

Expiration: One bonus term for options is the expiration date. This is the date that the options can no longer be exercised and become worthless. Unlike non-statutory options, the offering period for ISOs is always 10 years, after which time the options expire. If an employee is separated from the company prior to 10 years, they typically have 90 days to exercise options.

Employee Stock Option Basics

A stock option grant creates the opportunity to exercise the options at some later date at a predetermined price, called the strike price or exercise price. The option grant may vest over on a graduated scale with X% vesting each year for Y years, or all at once as a cliff at some future date. As with restricted stock, an employer’s goal in granting stock options is to incentivize the employee loyalty until they can exercise. 

Non-Qualified Stock Options (NSOs): A type of employee stock option where the employee pays ordinary income tax on the difference between the grant price and the price at which you exercise the option. 

Non-qualified stock options give employees the right to buy a set number of company shares within a specified timeframe at a preset price. Sometimes NSOs are offered as an alternative form of compensation to workers and as a means to encourage their loyalty to the company. The expectation is for the company’s share price to increase over time. This would mean the employee is potentially acquiring stock at a discount if the grant price is lower than future market prices. 

Tax Considerations for NSOs: If options are nonqualified, the difference between the strike price and the exercise price (aka the “bargain element”) is taxed as ordinary income at the time of exercise. This creates additional compensation/ordinary income, so employers typically withhold all of the taxes they would on your regular salary: federal and state income tax as well as Social Security/Medicare tax. Due to the tax ramifications, it’s common for employees with options to elect a “cashless exercise,” selling enough shares at the time of exercise to cover the cost of the shares and the related tax bill. The employee comes away with fewer shares, but the benefit is that there is no out-of-pocket expense to exercise the options.

As an example, Sandy received 100 shares of her employer’s stock in 2015, when it was trading at $5.00 per share, with a strike price of $10 per share and an expiration date of Dec. 31, 2024. If the stock were trading at $20 per share when Sandy wanted to exercise her options toward the end of 2024, the options would be in the money, meaning that the strike price is below the stock price at the time of exercise. (This difference: $20-$10 = $10 is the bargain element). Her profit would be on the difference between her $1,000 exercise price (her 100 stock options multiplied by the $10 strike price) and $2,000, the shares’ value at the time of exercise. Sandy earns $1,000 in additional ordinary income at the time of exercise ($10x100) and owes all the associated taxes noted above. She could either continue to hold the stock after exercise in the hope that it would go higher or sell and pocket her profit. The timing of the sale determines her capital gains treatment.

Incentive Stock Options (ISOs): ISOs are a corporate benefit giving an employee the right to buy shares of company stock at a discounted price with the added benefit of possible tax breaks on the profit. The profit on qualified ISOs is usually taxed at the capital gains rate and can vary between short-term and long-term depending on the holding period.

A key difference is that ISOs are not taxed as ordinary income at the time of exercise (unless the ISO holder sells the stock at the same time). Instead, there’s a tax benefit to holding the stock after exercising in order to qualify for the lower long-term capital gains rate on the profits from the sale. In order to qualify for long-term capital gains treatment, the employee must meet two criteria: 

  1. They must hold the options more than two years beyond the grant date and,
  2. They must hold the stock more than one year after exercise. 

To go back to the preceding example of stock options that were “in the money” (with a strike price of $10 and exercise price of $20), let’s assume Sandy exercised her stock options and hung on to the stock for another 18 months following her exercise, at which time she sells it for $30 per share. Due to the holding period, she is eligible for the long-term capital gains rate on the difference between her cost basis--$10/share--and her sale price of $30/share. A key detail, however, is that for all of her stock profit to be eligible for long-term capital gains treatment, she’d need to pony up for the $10/share exercise amount using external funds. If she needs to sell some shares to exercise her options, at least a portion of her gains will be taxable as ordinary income.

Beware of AMT:

An additional complication often associated with options is the alternative minimum tax (AMT). AMT is a parallel tax system originally designed to ensure that wealthy Americans pay their fair share of taxes. Taxpayers calculate their tax bills on the regular tax system as well as the AMT system, then pay whichever amount is higher. The current AMT rates in 2022 are 26% and 28%. A key difference between the two tax systems is that under the AMT system, ISOs are treated as income. On the AMT side, the bargain element (the difference between the grant price and the exercise price) is taxable as income at the time the options are exercised (but not sold). This is not the case as noted above with the regular tax system. 

Disclosure: This content is developed from sources believed to be providing accurate information, and provided by Verity Wealth Partners and Twenty Over Ten. It may not be used for the purpose of avoiding any federal tax penalties and should not be relied upon as tax advice. Always consult legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security.