In Depth Understanding of Employer Stock Compensation (Part 1)
Part 1 of a 2 part guide to your Employee Stock Purchase Program (ESPP), Restricted Stock (RSUs), Non-Qualified Stock Options (NSOs), and Incentive Stock Options (ISOs) (See Part 2 Here)
Whether you just started receiving employer stock as part of your compensation package or have been receiving it for several years, having a plan in place for managing this critical component of your income and net worth is essential.
But before we dive into the specific types of stock compensation, their taxing attributes, and planning opportunities around each type, let’s take a step back. Employer stock is just additional compensation in the form of company stock usually with some vesting period. Think of it as a bonus for a job well done. Instead of receiving cash, you receive stock. Often employees get caught up in the allure of employer stock as something they must continue to hold and not sell when vested or exercisable. This can be a dangerous way of thinking. If not thoughtfully planned and managed in an efficient way, you can inadvertently create unnecessary risk in your portfolio and potentially have adverse tax consequences down the road when you do liquidate.
To help provide a different perspective, take a moment to answer this question. If you received a $10,000 bonus today, in cash, would you go buy $10,000 of company stock? If the answer is no, you should not be building or holding onto your company stock. You already rely on wages from the company for your annual spending needs, don’t also tie retirement or other lifetime financial goals to your company’s performance.
Employee Stock Purchase Plans (ESPP)
This type of stock plan is a great way for employees to purchase company stock, often at discounted prices. Employees essentially contribute to the plan through after-tax payroll deductions (via your paycheck) which build up during the offering period.
At the end of each offering period those contributions are then used to purchase shares of stock which are then deposited into an investment account on behalf of the employees who participate in the plan.
To encourage participation in an ESPP employers often provide a discount to the purchase price, this can be from 0-15% for a tax qualified ESPP.
The grant date is the first day of the offering period and important when it comes to the tax impact – more to come on this. The grant date is also important if the plan provides a lookback provision. If the ESPP includes a “lookback provision”, the purchase price is determined by comparing the market value of the stock on the grant date (beginning of offering period) versus with the market value of the stock on the purchase date (end of the offering period) and applying the discount to the lower of the two prices.
For example, assume your company stock is trading at $10/share on the grant date, but on the purchase date (6 months later) the stock is trading at $12/share. Let us also assume your plan offers a 10% discount. With a look back provision, you would be able to purchase the stock at $9/share (using the lower of $10/share; plus applying that 10% discount or $1/share). With the stock trading at $12/share, that is a $3/share built in gain from the start!
These can be a great way to build additional wealth with minimal risk for those that have a plan in place to sell the shares.
The tax attributes of ESPP shares vary depending on whether you sell the shares in a qualifying or disqualifying disposition. While a qualifying disposition can provide preferential tax treatment, they may not always be the best strategy. For the sale to be considered a qualifying disposition the ESPP shares must meet both of the following two holding period requirements:
Sale of shares must occur at least two years from the grant date.
Sale of the shares must occur at least 1 year from the purchase date.
If either one of those requirements is not met, the sale will be classified as a disqualifying position. The gain on disqualifying dispositions are taxed at ordinary income rates, while qualifying dispositions are taxed at favorable long-term capital gains rates.
Below illustrates the tax difference between a qualifying and disqualifying dispositions:
Assumptions - taxpayer’s marginal rate is 25% and long-term capital gains rate is 15%
To keep the example simple, we excluded any discount as it will have no difference in taxes between a qualifying or disqualifying sale, the discount element is always subject to ordinary income rates. The corresponding income related to this will be reported on the employees W2 in the year of sale.
It is important to note that taxes are not withheld when ESPP shares are sold. This varies from Restricted Stock Units (RSUs) which we will discuss in a moment. Keep that in mind, when you realize gains on your ESPP shares you should factor in the tax impact and set that aside for taxes. This helps to remove any tax surprise when you go to file your taxes.
A couple planning opportunities surrounding ESPP shares, noted below:
Sell immediately to generate a quick profit (difference between sale price and discounted purchase price) and diversify the proceeds.
Hold the shares, let them appreciate and once you meet the two holding period requirements above for a qualifying sale, sell and realize a long-term capital gain on any appreciation. You should weigh the risks when employing this strategy, portfolio risk, company performance, and your tax situation. There are many factors to consider when employing this type of strategy and is best executed when working with your Financial and Tax advisor.
Restricted Stock Units (RSUs)
This form of compensation is pretty straight forward and common among publicly traded companies, especially where I live. Minneapolis is home to many publicly traded companies like Target, United Health Group, Best Buy, General Mills, Medtronic, and Boston Scientific to name a few.
Restricted stock units are company stock that is not transferable until certain conditions are met (vesting over a certain period). Once those restrictions are lifted the share ownership transfers to you and triggers a taxable event. The vesting period is not necessarily a bad thing, but it does mean you have to stay with the company during that vesting period to be able to unlock any potential value.
In many instances the vesting period is a certain percentage each year across several years - also known as graded vesting. For example, you are awarded 200 shares that will vest at 25% each year for the next four years. That means you will receive 50 shares each year for the next four years. At the end of year four you will have received all 200 shares if you’re still with the company.
There is also cliff vesting. This is where the entire shares vest at once but only after a certain number of years. For example, you are awarded 200 shares with a cliff vesting period of three years. You will receive all 200 shares only after the three years of service has been met, if you leave the company before then you will receive nothing.
The chart below illustrates the difference between graded and cliff vesting schedules:
Now that we have walked through the vesting requirements it’s time to understand the value of your RSUs once vested. The calculation is quite simple:
Total Value = Number of shares vested * Current Share Price.
Using our cliff vesting date of 200 shares in the previous example let’s say that the current share price upon the vesting date three years later is $50/share. The total value of those RSUs on the vesting date will be worth $10,000 (200 shares * $50/share).
The value of the vested shares is a taxable event and included in income in the year they vest, subject to ordinary income rates and payroll taxes. This is reported on your W2 in that year and taxes are withheld on the total value.
Once you’ve received your vested shares now what? In most instances we recommend selling the stock and diversifying the proceeds. This is to prevent accidentally building a concentrated position in your employer stock over time. In many instances we see highly paid executives receiving grants each year, these add up over time and soon you are receiving a substantial number of RSUs every year as they vest. It is important to have a plan in place ahead of time so you can execute the plan once they start vesting.
If you decide to hold the shares once vested there is another tax attribute to consider. As the stock price appreciates or depreciates this will create a capital gain or (loss) once the shares are finally sold. Depending on how long you hold the shares will ultimately determine whether any subsequent gain is taxed at short-term (ordinary income rates) or favorable long-term capital gains rates.
For the gain to be taxed at favorable long-term capital gains rates the shares must be held for more than a year. It is important to note that only the gain is taxed at capital gains rates, not the total value. The total value at the date of vest is always taxed as ordinary income and included in income the year of vest. It is only the subsequent gain from the date of vesting that would be subject to capital gains rates. This is a point worth noting, as I have run into several investors who think that by holding the vested shares for a year after vesting, it will provide favorable long-term capital gains treatment on the entire vested value also - this is not the case.
For example, lets assume 200 shares of stock vest today and the current price is $50/share. You also decide to hold onto the shares received instead of selling immediately as they vest. The total value of $10,000 would be included in income in the year of vesting. Your cost basis in the 200 shares is $10,000. After holding the shares for a year, the stock is now trading at $55/share – a capital gain of $5/share. If you decided to sell all 200 shares you would receive proceeds of $11,000 (220 * $55/share), realizing a long-term capital gain of $1,000 ($11,000 proceeds less your cost basis of $10,000).
A simply, but effective strategy to employ with RSUs is to just sell them as soon as they vest and diversify the proceeds. The vesting date triggers the taxes, you may as well sell the shares and reduce risk in the portfolio.
However, if you find yourself holding a concentrated position of RSUs that have built up over the years and are wondering how to reduce your company stock exposure in a tax efficient manner there are ways to do so but that is beyond the scope of this article – see Part 2.
Non-Qualified Stock Options (NSOs)
This is another form of employer stock popular with publicly traded companies as part of an employee’s overall compensation package. There are several important features related to NSOs to understand the potential value and tax impact of this form of employer stock.
NSOs provide an employee the option (at a future date) to purchase company stock at a preset price (exercise price). Similar to RSUs, NSOs have a vesting period before the employee is allowed to exercise the option. However, NSOs are not taxed when they vest only when the employee decides to exercise the option. You do not have to exercise the option on the vesting date, that is just the day the option first becomes available to you.
As previously mentioned, the option will come with an exercise or strike price per share. This is the price per share you pay to exercise the option. This is an important component of the option, as it determines the overall value of the option. Ultimately, you receive the spread between the current market value and the cost of exercising (exercise price) If the exercise price is below the current share price than it is in-the-money. If the exercise price is above the current share price you are out of-the-money – no value.
When you decide to exercise your options, you’ll have the choice of keeping the shares or selling them and take the proceeds. In either scenario taxes will be triggered on the difference between the exercise price and current stock price also known as the bargain element. This value is subject to Federal, State, Social Security, and Medicare tax and reported on your W2 in the year of exercise. A somewhat convenient feature of NSOs is that taxes are withheld when you exercise these. However, it’s important to note that the standard tax withholdings when exercising may not be enough to cover your tax liability. Consider preparing a tax projection in the year of sale to understand that tax impact with NSOs and really any employer stock sale.
Similar to RSUs, if you decide to hold the shares any subsequent gain after exercising will be taxed at capital gains rates – short or long-term depending on the holding period. It’s important to understand the additional risks to your portfolio by holding the shares. I understand the allure with holding the stock of a successful company. As the company succeeds, the share price is likely to rise and the potential upside for holding the shares increases. Remember, anything that can appreciate can also depreciate and you should weigh the benefits of taking on that additional risk.
A great feature of NSOs is the ability to choose what tax year to realize income and therefore taxes. With RSUs it’s a vesting date that cannot be changed. But with NSOs you are in control when you exercise. Now, assuming the options aren’t at risk of being out-of-the money, a good strategy to employ is exercising when your income drops. By exercising in years with decreased income you are exposing the bargain element to potentially lower tax rates.
Ideally you want to avoid pushing yourself into a higher marginal rate than you would normally be exposed to. Keep in mind this isn’t always possible as you should always weigh the benefits and risks of continuing to hold the options. Think about what your income is now and, in the future. Consider pushing a sale to January (if you are looking at a sale late in the tax year) to push the sale into a new year. Or consider spreading it across multiple tax years to avoid a spike in marginal rates. Another option for those about to retire is delay retirement into the early part of a new tax year (January or February) and then exercise the options in a year where earned income drops significantly because you retired.
Incentive Stock Options (ISOs)
ISOs are another form of stock compensation used today to attract and retain employees. It’s probably not as prevalent as the previous three employers’ stocks discussed but it can be a valuable wealth building tool if this is part of your overall compensation package. One of the main benefits of ISOs is they are eligible for much more favorable tax treatment compared to NSOs if certain conditions are met, which we will discuss shortly.
The overall characteristics work very similar to NSOs. ISOs provide an employee the option (at a future date) to purchase company stock at a preset price (exercise price). There is also a vesting period and once that is met, the employee will have the ability to exercise their options. Again, taxes only are incurred when exercised.
Where ISOs differ from NSOs is the potential for very favorable long-term capital gains rates versus ordinary income through a qualifying disposition. In order the sale to be a qualified sale the employee will need to meet the following two holding periods:
The stock sale must occur at least 2 years from the options grant date
The stock sale must occur at least 1 year after the date you exercised the stock.
If either one of these conditions are not met, the sale would be considered disqualifying and the entire bargain element (difference between the current stock price and exercise price) would be taxed as ordinary income.
Below illustrates the tax difference between a qualifying and disqualifying dispositions:
Assumptions - taxpayer’s marginal rate is 25% and long-term capital gains rate is 15%
As you can see in the above example the tax savings can be substantial – paying approximately 67% more in taxes in a disqualifying disposition compared to qualifying. While the allure of paying long-term capital gains rates versus ordinary income rates can be hard to pass up, it is not always that straightforward. Some things to consider when employing a strategy to achieve these favorable tax rates is risk and AMT (Alternative Minimum Tax).
Let’s start with a discussion on risk. It is important for everyone to consider the amount of risk they can afford to take when it comes to holding employer stock. If you have a considerable amount of employer stock that makes up most of your investable wealth, weigh the benefits of continuing to hold the stock to achieve long-term capital gains rate. If the stock takes a dive while you are trying to achieve long-term gains rates, that decline could cost you much more in lost value versus the tax savings.
Alternative minimum taxes are also important to consider when it comes to exercising ISOs. If an employee exercises options and holds the stock, the bargain element will be included for AMT tax purposes in the tax year. This can come as a huge surprise come tax time if not properly planned for and can cost employees thousands of dollars in extra taxes.
There are many things to consider when executing and managing an efficient sale of ISOs for employees and beyond the scope of this article. This article is meant to layout the basics around ISOs.
Summary of Employee Stock Compensation
If you were able to make it through the entire article you’ve probably started to see how complicated this can get and how important it is to integrate this part of your wealth with your overall financial plan to understand the risks and tax planning opportunities specific to your situation. In many instances you should be running annual tax projections to effectively execute stock sales. That is why it’s important to work closely with your financial advisor and tax advisor to craft a strategy specific to you.
If you have questions about your employer stock, utilizing effective sales strategies to reduce risk and taxes, or how this all relates to your retirement plan, schedule a phone call to discuss with a Phillip James advisor.
All the information contained herein is for illustrative purposes and should not be relied upon for tax, investment, or legal advice. You should consult with your fee-only financial advisor to decide what is best for you based on your specific situation. It also helps if your advisor is a tax advisor to understand the tax impact of implementing specific strategies.