Many companies, particularly in the tech and biotech sectors, offer stock options as part of their compensation packages. These options serve not only to compete with larger companies in terms of salaries, but also to motivate and incentivize employees. By granting partial ownership in the company, employees are encouraged to contribute to its growth, knowing that their efforts can directly impact the value of the company's stock. The more the company’s stock is worth, the more the employees stand to benefit.

Regardless of the type of options offered, there’s a good chance that they will have a profound impact on your tax implications and your portfolio allocation over time. For these reasons, we strongly recommend that you work closely with a Certified Financial Planner (CFP) and Certified Public Accountant (CPA) to plan out a strategy to optimize these benefits so that they can work well within your own overall financial plan. 

Some of these incentives are fairly straightforward, but others can be quite complicated. We don’t necessarily recommend going it alone, but we do believe that you should be well-informed and knowledgeable of the various benefits you may have available. Here’s some general information and rules about some of these benefits.

Equity Compensation Benefits

This is a brief overview of the more common types of equity compensation / employer stock benefits we see with the clients we serve. You can learn more about the services we provide under the How We Help section of our website.

Restricted Stock Units (RSUs):

These are one of the less complex options available and are arguably the most common. RSUs are stock awards given to an employee by the company. At the time of issuance (or grant), there is no monetary value to the employee.

These are provided as incentives and have a vesting schedule that the company dictates. Vesting is when the shares of stock are officially transferred from the company to the employee, and there are various vesting schedules that companies can use.

Once the shares vest, they are transferred to the employee and are considered income for tax purposes, computed as the number of shares vesting multiplied by the fair market value of the shares. A portion of the shares are typically withheld to pay income taxes, but the rest are now owned by the employee.

After they vest, RSUs are treated as regular stock ownership, with the cost basis being the fair market value on the vesting date. They can be sold immediately for short-term gain/loss or held for over a year for long-term capital gain/loss treatment.

Despite some shares being withheld for taxes, it’s likely that you’ll still have a tax liability. It’s also important to maintain a diversified portfolio without having too large an allocation to your employer’s stock. Every situation is unique and should be thoughtfully planned out with your financial planner and CPA.

Employee Stock Purchase Plans (ESPPs):

These are another fairly common employer benefit. These plans are a little more complex than RSUs. Generally speaking, contributions are deducted from your paycheck on an after-tax basis and placed in an escrow account. On the purchase date (selected by the company), the accumulated funds will be used to buy company shares at a discount. The discount amount depends on the company’s plan setup but can be up to 15%.

With ESPP shares, no taxes are due until you sell the shares. However, that’s the only simple part of the tax considerations. The taxes are a bit tricky and depend on whether your company offers a qualified or non-qualified ESPP, and the length of time between the sales date, and the grant and purchase dates.

Usually, the difference between the discount price and the calculated fair market value (FMV) will be taxed as ordinary income when the shares are sold, with the FMV being the cost basis. If the shares are held for 12+ months, the difference between sale price and cost basis will be a long-term capital gain/loss, or it will be treated as ordinary income if held for less than 12 months.

The determination for the fair market value is based on the qualifying factors. Generally, qualified plans that meet the holding requirements use the FMV of the offer date or purchase date, whichever is lower. Non-qualified plans, or failure to meet the holding period requirements, will result in using the higher of the FMV prices. Remember, ordinary income taxes are due on the difference between the FMV and the discount price, so these differences could have a major impact on your tax liability.

For more detailed tax information, you can check out this TurboTax article. Due to all these unique rules regarding ESPPs, we strongly recommend working with a CPA and CFP to determine the best course of action for your own individual financial plan. 

Incentive Stock Options (ISOs):

These are slightly less common and are typically awarded to high-level employees. Unlike the previous benefits plans, these are options contracts that give the employee the option to buy a predetermined number of shares at a specified price (typically the market price on the grant date).

Once the ISOs are granted, the employee must hold them for a specified period (the vesting period) before anything can be done with them. Once the vesting period is over, the employee has the option to exercise the ISOs (or buy the vested number of shares at the grant price).

Ideally, the current market price for the company’s stock is above the grant price, so the employee can buy the stock at a discount. If the current market price isn’t favorable, the employee can hold onto ISOs for up to ten years (depending on plan specifics) before exercising them (buying the stock).

After the employee exercises the ISOs, they now hold the shares of the company. They can be sold or held as the employee desires. Tax treatment for ISOs is similar to that of ESPP. To receive preferential tax treatment, the shares must be held for at least two years from the grant date, AND one year from the exercise date. If both of these holding periods are met, then any profit/loss is taxed as long-term capital gains.

If one of the holding periods is not met, then the bargain element (difference between the exercise price and FMV on the date of exercise) is taxed as ordinary income. The FMV becomes the new cost basis. Any profit/loss from the sale is taxed as either short- or long-term capital gains rates depending on how long the actual stock was held.

There is a possibility that exercising ISOs can trigger the Alternative Minimum Tax (AMT). You can learn more about that and view some examples here.

Non-Qualified Stock Options (NSOs):

These are a little more common than ISOs and are a bit more straightforward. Like ISOs, these are options contracts that provide the employee with the option to purchase a specific number of shares of the company at a predetermined price.

When NSOs are granted to an employee, the purchase price is usually close to the fair market value of the stock. NSOs also typically have a vesting period that must be satisfied before the options can be exercised (shares can be bought at the grant price). The NSOs also have an expiration date and will be void if not exercised before the expiration date. In these aspects, ISOs and NSOs are very similar.

The primary difference between ISOs and NSOs is the tax treatment. The “non-qualified” part of their name references the fact that these options don’t qualify for the special tax treatment of ISOs.

When NSOs are exercised, the employee will have to pay ordinary income tax on the difference between the purchase (or strike) price, and the actual market price on the exercise date (if bought at a discount). Many employers will list this difference as income on the employee’s w-2 for that year.

Once exercised, NSOs are treated the same as any other stock, with the cost-basis being equal to the market price on the exercise date. If you hold the stock for one year or less, any gain/loss will be classified as short-term, and will be taxed accordingly. If the shares are held for more than one year before being sold, any gain/loss will be classified as a long-term capital gain/loss and will be taxed accordingly.

TurboTax provides some good examples of NSOs and their tax considerations.

Employee Stock Ownership Plans (ESOPs):

These are qualified plans in which employers provide employees with shares of the company stock, which are typically held in a trust fund. These plans are tax-deferred, so no taxes are due until funds or shares are withdrawn from the plan.

The number of provided shares is usually based on the employee’s tenure with the company, and there is typically some sort of vesting period to promote retention. The purpose of ESOPs are to provide employees with ownership of the company, motivating them to be committed to its improvement.

Since it’s a qualified plan, there are restrictions to accessing these shares. Generally, the employee must wait until their employment with the company is terminated, but each plan is unique. There are also typically tax penalties of 10% for early withdrawal (before age 59 ½).

Tax consequences for these plans can be quite complex and are dependent on the type of company and type of plan. Upon separation from employment with the company, you may be able to roll these over into an IRA to keep the tax-deferred status, take a lump-sum distribution with the entire amount taxed as ordinary income, or transfer the shares to a taxable account (if allowed).

When transferring to a taxable account, there may be special tax considerations. Under certain circumstances, you may just owe ordinary income taxes on the actual cost basis. The shares would then be treated as other stock holdings, being taxed as short- or long-term capital gains when sold. The holding period includes the time the shares were held in the ESOP. If your plan doesn’t allow this, or these special circumstances don’t apply, then the entire value of the account would be taxed as ordinary income when transferred over.

It’s important to understand the specific details of your ESOP, and consult with your CPA and Financial Planner to determine the optimal way to withdraw these funds.

Final Thoughts:

Receiving or participating in the equity-compensation benefits offered by your employer can be a great way to build wealth and save for retirement or other future expenses. But keep in mind that no investment is without risk, so you’ll want to be sure not to over-expose yourself to your company’s risk. It’s recommended to maintain a diversified investment portfolio, with your employer’s stock only representing a small percentage.

It’s also important to consider the tax implications of your equity compensation benefits, especially if your company offers more than one of these benefits, and if you’re in a high tax bracket. I’m sure you don’t want taxes to take too big of a bite out of your equity compensation.

The provided explanations are only generic in nature, and your specific benefits will likely have some unique features. It’s important to review the benefit documents provided by your employer and work closely with your Financial Planner and CPA to determine the optimal strategy for your unique situation and your company’s unique benefits offerings.

If you have questions about your employer benefits or any other financial planning subject, you can use the calendar link below to schedule a free Introductory Conversation to learn how we may be able to help.

PS:

If you’re a small business owner who’s thinking about taking your company public in the future, you may want to consider offering some of these stock options to your employees. It’s a great benefit for the employees, and they typically offer some advantages to the employer. Including stock options may allow you to bring in or retain top talent during the first few years when cash may be tight. Many of these are also tax-deductible to the business.

SFA and Bowers Private Wealth Management do not offer tax or legal advice.