LEVATUS Wealth | High Impact Employee Stock Option Strategy
Being awarded stock options by your company is a cherished benefit. Don’t blow it.
Cash flow and investment planning around employee stock options can be tricky, and its not just the tax treatment that can trip up plan participants. A thoughtful plan that speaks to investment exposure, risk concentrations, cash flow management, and tax planning, helps to cover all the bases.
Stock options are a cherished perk. For employee’s, stock option plans are a chance to invest in the company's success and potentially make money if the stock price goes up. For companies, the plans are an opportunity to recognize important contributions, create incentives, and reward employees. When companies do well the value of stock options can become substantial, especially for early members of the team. Managing this concentration, staying on top of option schedule logistics, integrating cash flow impacts, and thinking about tax exposures, are important elements of fully optimizing your stock option holdings.
To develop your understanding of the many moving pieces around stock option planning, it is helpful to start with a few definitions. The most common forms of employee stock option grants fall into a few buckets:
Incentive stock options (ISO)
These allow employees to buy company stock at a discounted price. To receive favorable tax treatment, employees must hold the ISO stock for at least two years after the grant date and one year after exercising the options.
Non-qualified stock options (NQ/NSO):
These can be given to employees, independent contractors, partners, vendors, and others not on the company payroll. NSOs don't have the same tax advantages as ISOs for plan participants, but are popular because they allow the company to get a tax deduction when the options are exercised.
Differences in Tax Treatment
The tax treatment for these two types of grants each have important nuances, and it is always best to work with an accountant to understand your specific situation. Non-qualified stock options (NSO) are more common because companies can deduct compensation expenses when employees exercise them. Taxation for the employee occurs at the time of exercise, not when the stock is initially granted.
Once you exercise your non-qualified stock option (NQ/NSO) and receive the stock, the difference between the stock price and the strike price on the option is taxed as ordinary income. This income is usually reported on your paystub. There are no tax consequences when you first receive your non-qualified stock option, only when you exercise your option (receive the stock) and of course, capital gains if you sell the stock you have received down the road at a higher price.
As an example, if an employee is granted Non Qualified Stock Options (NQ/NSO) with a strike price of $5 per share and exercises them when the stock price is trading at $10 per share, they will be taxed on the $5 difference per share as part of their ordinary income. This happens when the option is exercised and the stock received, regardless of whether the stock is then sold or held.
For Incentive Stock Options (ISOs), this taxable event takes place when the stock is sold. ISOs can receive favorable tax treatment but only after meeting specific holding requirements (holding the stock for at least two years after the grant date and one year after exercising the options). Once past these holding period requirements, profits would be taxes at the capital gains rate rather than the income tax rate.
Bottom line: ISO v NQ/NSO
Tax treatment for ISOs and NSOs have important differences. These differences can have a significant on impact cash requirements and optimal holding period. As always, speak with a qualified accountant to understand your specific situation.
Restricted Stock Unit (RSU):
RSUs are a different form of equity-based compensation commonly offered to employees by companies. RSUs are often subject to a vesting period before the employee gains full ownership of the granted shares.
An RSU is a promise by the company to give the employee a certain number of company shares after a vesting period. The shares are granted as part of the company's compensation plan, and once they vest, the employee receives the actual company stock.
RSUs are different from stock options in that they don't require the employee to purchase the stock; they are granted shares directly after the vesting period. The value of RSUs is based on the company's stock price at the time of vesting. When the RSUs vest, the employee typically receives the shares or their cash equivalent, and the value of the vested RSUs is considered taxable income for the employee.
When you receive an RSU, you generally won't have any immediate tax liability. In most cases an employee is required to pay taxes when your RSU vests and they receive an actual payout of stock shares. At that point, you must report income based on the fair market value of the stock. You may also implement a ‘netting strategy’ whereby enough shares are sold to cover the income tax associated with vesting. At the time of vesting, the fair market value of the company's stock is used as the cost basis for the employee. This cost basis is essential for tax purposes, as it determines the amount of taxable income the employee must report when the RSUs are vested.
For example, if an employee receives 100 RSUs, and at the time of vesting, the company's stock is valued at $50 per share, then the cost basis for those 100 shares would be $50 x 100 = $5,000. An employee would then have $5000 of income tax liability and $5000 worth of stock. Some part of this stock could be sold to net out the income tax liability.
When the employee sells the vested shares at some point down the road, the capital gains tax will be calculated based on the difference between the selling price and the cost basis (fair market value at the time of vesting). If the employee sells the shares at a price higher than the fair market value at vesting, they will have a capital gain, and if they sell at a lower price, they will have a capital loss.
It's important for employees to keep track of the cost basis of their RSUs to accurately report their taxable income and capital gains or losses when they decide to sell the shares. As tax laws can be complex, it's always advisable to consult with a tax professional for personalized guidance regarding RSUs and other equity-based compensation.
Financial Strategy Beyond the Taxes
Cash Flow
Managing cash flow around stock option exercises is a critical piece of puzzle in financial planning. When you exercise a stock option it means you are buying the shares at the strike price, which means you have to pay for the shares. In some cases you may sell some of the shares you have received to cover the cost, but if you prefer not to do this, you will have to identify other sources of liquidity to cover the expense. Since the vesting date is a known date, the best strategy is always to identify the source of funds for the exercise well in advance. Cash requirements to pay any taxes due is another important element of cash planning.
Life Events
Sound financial planning around employee stock option plans also needs to include the possibility of other events, such as the decision to leave a company for personal reasons, or a company driven lay-off. In each of these cases option terms may change, or the value of unvested options disappears. In the case of lay-offs there is often an acceleration in option terms, just at the moment when the feeling of financial vulnerability might make it tough to spend money to exercise options and buy shares. Advanced planning for these potential outcomes is critical to successfully navigating what can be a very stressful time.
Concentration Risk
In deciding how much company stock to hold on to, it is important to consider not only the amount of investment exposure, but also the amount of personal exposure through employment. Being aware of total financial concentration, including both stock value and cash flow through salary, gives you a more complete picture of risk.
Employee stock options can be a fantastic bonus for employees. Speaking with a tax and financial professional can help you personalize a plan that fits for you, and incorporates the nuances of your career plans as well as the outlook for your company.
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ABOUT THE AUTHOR
Susan Dahl is a well regarded executive, female industry leader, and dedicated client advisor with over twenty-five years of experience. Susan writes on topics such as investing, strategy and financial planning, and is the author of the blog series Female Advisor Perspective, a look into the analysis, process, and planning insights that emerge when problem solving is viewed through the unique lens of experienced female financial advisors. Susan’s deep and diverse background extends from global investing to risk management to change leadership. This background has laid the groundwork for an approach that asks more of wealth. She shares some her most recent work in a talk for TEDx, Can Happy Make You Money?