Equity-based compensation can be a major component of the employee benefit package at growing companies. As companies gain traction and financial success, it is important that employees understand the intricacies of the equity awards they've accumulated over their tenure in order to maximize their value and mitigate risks.
A major event such as an IPO of the company stock amplifies the need for a thoughtful financial strategy around an employee’s equity holdings, which can suddenly represent a significant portion of their overall wealth. Investment diversification, risk mitigation, and tax minimization strategies around realizing the value of these hard earned equity awards are imperative to achieving personal wealth goals. The new variable of public stock market exposure may pose some challenges to maximizing wealth, but also introduces many new opportunities to do the same.
Stock Options Like Lower Stock Prices.
Stock options are a popular form of equity compensation for executives or key employees. In most plans, once a predetermined set of criteria is met, such as a vesting schedule, participants have the right to purchase shares of the company at a predetermined grant price. If the stock price has increased in the time since the options were granted, the options are considered to be “in-the-money" (ITM) and, upon exercising their option to purchase the shares, the participant will have instantaneous value above their purchase price. However, choosing to exercise stock options can have significant tax consequences, which depend on the type of the stock option they are.
The exercise of ITM Incentive Stock Options (ISO), can cause an increase in the Alternative Minimum Tax for the individual. Even in today’s tax environment of significantly increased AMT exemptions and phase-out thresholds, this tax is still often an issue for people who receive a substantial amount of their income in the form of ISOs.
For non-qualified stock option (NQSO), compensation income is recognized by the plan participant at the time of exercise based on the spread between the option price and the exercise price and is taxed at ordinary tax rates and subject to payroll taxes.
In both cases, the exercise of stock options causes a phantom income effect, which results in the individual having to pay taxes on compensation that they haven’t received in the form of cash. As a result, many plan participants need to sell a portion of the stock they just exercised their right to purchase in order to generate cash to pay taxes.
Exercising both ISOs and NQSOs at lower stock prices has the impact of reducing the amount of AMT or ordinary income that is recognized upon exercise, thus reducing the tax burden of the phantom income. In turn, fewer (or no) shares need to be sold to cover taxes, and the remaining shares can be held by the individual, where they can hopefully appreciate and be sold in the future at preferential long-term capital gains rates.
For participants who continue to be granted stock options, periods of lower stock prices offer an opportunity for grants that will more easily achieve ITM status in the future as markets and economies continue to recover.
Restricted Stock Units Do, Too.
Restricted Stock Units, or “RSUs” also benefit from vesting when stock prices are abnormally depressed. Like stock options, plan participants are often subject to a vesting schedule before their right to receive or benefit from the equity compensation occurs. Generally, at the time restricted stock vests, individuals must recognize income, which is subject to taxes at ordinary rates, including payroll taxes. Typically, a portion of the vested shares are immediately sold upon vesting to cover this tax liability. The income recognition event for the RSUs sets the new basis and start of the holding period for the stock to determine capital gains/losses and the nature of the gain when it is sold in the future.
Vesting at a lower stock price reduces the amount of ordinary income recognized, and results in more net shares usually being retained. Additionally, if the remaining stock is held for more than a year, the appreciation beyond the vesting price is taxed at long-term capital gains rates when the stock is sold.
For individuals who continue to receive RSU grants, volatile markets may provide an opportunity to achieve some tax savings as well. Within 30 days of receiving an RSU grant, a participant may choose to make a Section 83(b) election. With this election, an individual is choosing to be taxed on the RSU compensation based on the FMV of the stock at the time of grant, rather than at the time of vesting. In a down market, this can result in tremendous tax savings if the stock price rapidly recovers throughout the subsequent vesting period. Additionally, if the participant expects the stock price to soar from the current stable price because of new markets or revenue opportunities, a Section 83(b) election may be useful in achieving tax savings as well.
Section 83(b) elections are not without risks. If an individual does not meet the vesting requirements and the award is forfeited, taxes paid based on the grant cannot be recovered. Additionally, if the stock price falls further throughout the vesting period, income will have already been recognized at a higher amount than they would have if the election was not made.
Employee Stock Purchase Plan Lookbacks and Deep Discounts.
Many rank and file employees at public companies can participate in Employee Stock Purchase Plans (ESPP). Typically, in these plans, participants agree to allocate a portion of their compensation towards the purchase of company stock during an offering period, usually at a discounted price of up to 15%. Plans frequently incorporate lookback provisions, which allow the stock price to be based on the lower of the stock price on the first or last day of the offering period.
If the offering period starts during a time where the stock price is abnormally low and then subsequently soars, at the end of the offering period the ESPP participant in a plan with a discount and look back provision has the ability to purchase shares at the lower price and at a discount! There are holding period requirements in order to achieve maximum tax efficiency on ESPP shares, but even if shares are sold in “disqualifying dispositions” the net value realized by the participant can be substantial.
Some plans also offer the opportunity for an adjustment to the amount of compensation committed to the purchase ESPP shares during the offering period. During times of volatility, participants in plans with these types of provisions should be mindful of this ability. If there is a discount provision and the stock decreases in value over the offering period, the individual may, at worst, just reap the rewards of the “sale price” if they quickly sell the stock in a disqualifying disposition. However, if the stock is plunging quickly, the adjustment provision may be a lifeline in stopping the participant from catching a falling sword. (Of course, they may have bigger worries like getting their CV up to date!) Stock based compensation plans may offer employees and executives at successful companies a pathway to tremendous financial success. However, thoughtful planning around the exercise of options, the recognition of income, and tax efficient coordination of equity-based compensation is extremely important in maximizing this form of compensation, particularly when it represents most of an employee's compensation and personal cash flow is of concern.
With the prospect of continued market volatility in the months ahead, and significantly increased tax rates on the horizon, comprehensive planning in this area has never been as important as today. It is important to work with an adviser who has a holistic understanding of your wealth, personal cashflow, tax situation, and personal and professional goals in order to achieve a successful financial plan around your stock-based compensation.
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© 2021 Sanderson Wealth Management LLC. This information is not intended to be and should not be treated as legal, investment, accounting or tax advice and is for informational purposes only. Readers, including professionals, should under no circumstances rely upon this information as a substitute for their own research or for obtaining specific legal, accounting, or tax advice from their own counsel. All information discussed herein is current as of the date appearing in this material and is subject to change at any time without notice. Opinions expressed are those of the author, do not necessarily reflect the opinions of Sanderson Wealth Management, and are subject to change without notice. The information has been obtained from sources believed to be reliable, but its accuracy and interpretation are not guaranteed.
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