As an executive, company stock or stock options are likely a major component of your compensation package. (Grants, Non-Qualified Stock Options, Restricted Stock Units, etc.)
Currently, you are most likely focusing your time and energy on making it to the other side of COVID 19 as whole and profitable as possible. And you absolutely should be focused on this.
However, maintaining a firm grip on your employer stock options/ restricted stock, or outsourcing this task to your Personal CFO, might pay off tremendously from a tax perspective.
Non-Qualified Stock Options(NSOs) and Incentive Stock Options (ISOs)
Incentive Stock Options and Non-Qualified Stock Options both offer employees the right, within a designated timeframe, to buy a set number of shares of their company’s stock at a specified price.
ISOs can only be granted to employees. NSOs can be granted to anyone, including employees, consultants, and directors.
The primary difference between the two is how they are taxed (Please reference Exhibit A below).
Restricted Stock and Restricted Stock Units (RSUs)
Restricted stock is an equity vehicle that transfers the stock to the recipient on the date of the grant subject to certain vesting restrictions.
Restricted Stock Units (RSUs) on the other hand, are not an actual transfer of stock on the grant date, but rather a commitment to transfer stock or cash equivalent once vesting conditions are met.
Non-Qualified Stock Options and Incentive Stock Options Examples:
In a “cash” transaction, in order to exercise your stock option, you come out of pocket and pay for the stock at the grant price in cash.
In a “cashless” transaction, you would use the “spread” (difference between the market price of the stock and the grant price) to pay for a certain amount of shares of stock.
In other words, you exercise your options to purchase stock and pay for it by selling some of this stock.
Most people choose to exercise their options via a “cashless” transaction, quite simply, because of lack of cash elsewhere.
If you have a high level of conviction in the upside opportunity of your employer’s stock, you might want to consider a “cash” transaction, as this will allow you to retain more shares than a “cashless” transaction. Depending on your level of optimism around your employer’s stock, one might even consider adding a secured line of credit to his or her brokerage account to create the liquidity to move forward with a “cash transaction”.
Nevertheless there is a good chance you are in one of the three following scenarios:
- Your company’s stock price is growing and is currently higher than the exercise price
- Your company’s stock price is falling but is still currently higher than the exercise price
- Your company’s stock price is below your exercise price
Scenario 1: Your company’s stock price is growing and is currently higher than the exercise price
Many people think that if they exercise their options and purchase their company’s stock while the stock price is much higher than the exercise price, they win. Yes, on paper they make money, but this does not necessarily constitute as a win.
With NSOs, you pay ordinary income tax on the difference between the market price and the exercise price. Subsequently, you will pay capital gains tax on the difference between the market price of the stock when you exercise your options and when you sell the stock down the road, assuming you hold it for more than one year.
Therefore, in a perfect world, you would exercise your option when the stock price is as close to exercise price as possible. This means that, from a tax perspective, you might hope that your company’s stock price declines in value before you exercise your options.
Because the tax is higher in this scenario, it might make sense to proceed with a cashless transaction. This means you use gains from your stock options as the cash to purchase the stock.
ISOs could differ. When you exercise an ISO, no ordinary income tax is due, but the difference between the fair market value on the day you exercise and the exercise price is factored into your Alternative Minimum Tax (AMT) calculation.
If you sell your stock at the later of 2 years after the grant date or 1 year after the exercise date, the appreciation on your stock will be taxed at Long Term Capital Gains.
So, the question is this: will the AMT figure described above result in more tax than the long-term capital gains tax assuming you hold the stock long enough?
Scenario 2: Your company’s stock price is falling, but is still currently higher than the exercise price
From a tax perspective, this can be a great camp to be in. Of course, you probably do not want to exercise stock options to purchase shares of a company that might have solvency concerns. However, paying less in ordinary income taxes today, with the hopes that your company’s stock price rebounds and grows into the future (at which you can pay long term capital gains tax on a liquidation), is certainly the ideal scenario.
In this scenario, if you have a bright outlook as to the future of your company, you might want to consider a cash transaction. It could even make sense to tap lines of credit from a securities portfolio to come up with the cash to exercise your options and purchase your stock.
AMT would be less of a concern in this scenario. Once again, here we must weigh the impact of the AMT consideration versus the anticipated long-term capital gains tax when you sell the stock later on.
Scenario 3:Your company’s stock price is below your exercise price
This is an interesting position to be in. Regardless of NSOs vs. ISOs, here are the questions I would ask myself if I were in this position:
- Is my company’s stock public or private?
- If public- I could simply purchase shares on the open market, at the market price which is lower than my exercise price.
- If private- depending on the outlook I have surrounding the future of my company, I still might want to exercise these options, even if I am paying a premium for the shares. This decision boils down to the following factors:
- How optimistic are you about the future of your company?
- What is your access to purchase additional equity? If an opportunity to purchase additional equity rarely presents itself, and you are optimistic about the growth of your company, it might make sense to pay a premium and exercise your options.
Considerations for Restricted Stock
The primary consideration regarding Restricted Stock is whether to make an 83(b) election. (An 83(b) election allows you to recognize the value of the restricted stock at the time it is granted as opposed to in the future when the stock vests.)
If you do not make an 83(b) election, you will not recognize ordinary income on the day you are granted the restricted stock. However, you will recognize ordinary income on the fair market value of the stock when you are vested.
If you make an 83(b) election upon receiving Restricted Stock, you will recognize ordinary income on the value of the stock on the day you are granted the restricted stock, but you are not taxed again when the stock vests.
If you think the price of your company’s stock will appreciate, it might be wise to bite the bullet, make the 83(b) election, and pay the tax now, potentially on a lower value.
However, this does come with risks. If you do not meet the requirements for your Restricted Stock to vest, you might walk away without stock that you have already paid taxes on.
Considerations for Restricted Stock Units (RSUs)
The main thing to consider is how the RSU is to be settled upon vesting.
An RSU can either be settled in stock or cash upon vesting.
If settled in stock, you would recognize ordinary income at the fair market value on the date the shares are transferred to you. If settled in cash, you would recognize ordinary income in the taxable year in which you actually or constructively receive the cash payment.
This means that your W-2 wages might be higher, resulting in an increased tax liability, for money you might not be able to access right away.
How To Proceed Effectively
Whenever we aim to make prudent financial decisions, most of the time there are many factors to consider.
Unfortunately, time is finite, and your time and energy might best be utilized by leading your company to a fruitful future as opposed to staying up to date on the best tax strategies for your restricted stock or stock options.
Therefore, it can make sense to outsource this type of work to a team of qualified professionals who can manage your personal financial affairs with the same level of engagement that you manage your company.