Stock Compensation and Strategy

Many businesses offer stock or stock options as a component of overall compensation. These equity incentive programs may appear to be a great benefit, but they must be carefully managed, just like any other source of income, to avoid upsetting your financial strategy or posing a significant tax burden.

TL;DR

The most common misconceptions about equity incentive programs relate to taxation and vesting.

·??RSU: Taxed immediately upon vesting using the FMV of the vested shares, usually vest over a period of years, and you can sell them directly. No tax benefit to holding after they vest.

·??ESPP: Equity incentive programs give you the opportunity to use your salary to build additional wealth beyond your regular compensation. However, concentration risk tax issues also pose significant risks to financial planning.

·??ISO: Subject to vesting schedules, may create AMT liability when exercised, and must be held for 2 years from grant and 1 year from exercise to apply LTCG. Typically, they expire after 10 years.

RSU

You may receive these as part of your annual performance assessment or generally as part of your overall compensation package. The majority of RSUs have a vesting schedule, so you don't receive the full value from the outset. If your company grants you 100 RSUs, for instance, you'll probably get 25 shares to vest each year (typically on a quarterly schedule) until you get all 100 shares to vest in four years.

RSUs give you an interest in the company but no actual value until they are vested. Upon vesting, the Fair Market Value (FMV) of the shares is considered income. You will then have the right to sell the vested shares and receive the cash proceeds or hold the shares for a longer period.

Regarding Taxes

Once the RSUs vest you can sell and convert the shares to cash. Alternatively, you may keep the shares, but any gains you made after the vesting date would be taxed as capital gains. You could also decide to hold the shares and not convert them to cash. If you hold shares and they drop in value, you might be faced with selling at a loss in addition to paying tax on value you never actually received.

Many people are not aware that this type of compensation is taxed upon vesting. Your paycheck will include the FMV of any shares after they have vested, and you will be required to pay taxes on them along with the rest of your income. While it is typical for the employer to sell enough to cover some of the taxes due, in many cases they do not sell and withhold quite enough to cover the full tax liability.

If you earned $200,000 in salary your employer will withhold an amount of that income to cover Federal Income taxes based on salary. But, if your RSU grant vested another 150K worth of shares during the year, your marginal tax bracket will have increased making the company’s withholding insufficient.

Strategy

RSUs accrue over time and, if held, can lead to a significantly consolidated position in one firm. An experienced executive might start with 100 shares vested, then 200, then 300, and so on. Suddenly, they discover that a sizable chunk of their holdings, perhaps also a significant percentage of their net worth, consists of company stock.

Accumulation of company stock can lead to more than just lack of portfolio diversification. Generally, having a sizable stock position in the same company that also pays your salary isn’t advisable. If that organization, for a myriad of reasons, experiences a downturn this could have a double-whammy effect.

It may be advisable to sell all RSUs as they vest. By converting the shares to cash you will be better able to manage taxes due and invest proceeds in a more diverse manner. This should provide you with greater and more predictable long-term success.

ESPP

The Employee Stock Purchase Program (ESPP) is another program offered by publicly traded companies. In Qualified ESPP Plans employees can purchase company stock at a discount of up to 15% with a contribution limit of 15% of their income up to $25,000 annually.

Assuming you make $200,000, 15% of your income will be $30,000, but your max contribution would be $25,000. To participate, you can contribute a percentage of all your paychecks to the stock purchase program. When it comes to taxing these incentives, things get even more complicated.?

Regarding taxes

Suppose you’ve bought up to the limit of your company stock at a 15% discount. This means that you are already making a profit compared to the market price. Once sold, these stocks will trigger tax liability. If you don’t satisfy the ESPP holding period (2 years from enrollment/grant and 1 year from purchase) you will have an ordinary income tax on the spread at purchase and, you may have more short-term gains if the sale price is higher than the fair market value on purchase date.

Strategy

ESPPs are generally a good deal as they give you access to shares at discounts of up to 15% (percentages vary by company). The strategy we recommend depends on the situation at hand, including your income and your personal objectives.

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ISO

Incentive Stock Options (ISO) are the last of the most common stock incentive programs. They are issued by public companies or private companies planning to go public in the future. They are most typically offered to executives and highly valued employees.

An ISO provides an 'option' to purchase shares in a company at a set price, called the 'strike price', for a specified period. Like RSUs, ISOs are typically subject to a vesting schedule that could be 3 or 4 years. As the ISOs vest, you can exercise them at the strike price stated in the grant. Employees may have 10 years to exercise their options before they expire. Once you exercise vested shares, you now own the shares at the strike price. You may hold them or sell them immediately, but there are several things to consider.

Regarding taxes

ISOs have the most complex tax issues of the 3 stock options discussed. When you exercise your ISOs, you don’t receive any proceeds, as the exercise is only the purchase of the stock. Although you didn’t receive any proceeds, you may still trigger a tax liability. This tax liability is created by the spread, or difference between, the Fair Market Value (FMV) and the Strike price you were granted. This spread is often referred to as the ‘Bargain Element’, and if large enough, will trigger what is known as Alternative Minimum Tax (AMT). This can be very complex and confusing as many employees are unaware of this and are caught off guard by their sometimes-significant tax liability due to AMT. ?

When you calculate your taxes each year, you must calculate in two ways. The first is the more common way, where you arrive at taxes due using your ordinary income (employment, investments, real estate, etc.), less your deductions.

AMT runs parallel to the standard tax, but has different tax rates, and eliminates many deductions and tax breaks you normally use to reduce taxable income. Additionally, the bargain element present when you exercise stock options is also included in AMT calculations. Once you arrive at the AMT version of your taxable income you reduce it by the exemption amount before arriving at a figure to multiply by the applicable AMT tax rates. If you end up owing more tax under the AMT rules than you would have owed under regular tax rules, you pay the higher amount. ??

AMT taxes due to ISO exercises can be alarming if you aren’t prepared. We help our clients understand the AMT involved with their ISO strategy, and the ways that they can use any excess AMT payments as credits against future taxes in years when they aren’t subject to AMT.

In addition to possible AMT the bargain element creates, there are also capital gains taxes due. The gains can be short term, or long term if you held the shares for over a year from exercise and two years from grant. Holding for Long Term Capital Gains (LTCG) greatly reduces your overall tax liability but sometimes it might be appropriate to sell at short term gains depending on your circumstances.

Strategy

We generally recommend exercising options as soon as they vest and holding for 12 months to apply long term capital gains treatment. Your specific strategy may vary based on your goals, but generally we advise selling and reinvesting the proceeds in a more diverse portfolio.

?If your employer offers these unique and valuable benefits, we encourage you to consult with an experienced financial planner to develop a solid strategy for maximizing your?wealth.