Stock Options and Other Equity Awards Explained

 By Robert Bartley

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With the labor market humming, employers are beginning to get creative with their perks for prospective workers. Salary and wages are always going to be at the forefront of the compensation package, but sign-on bonuses, paid time off, college tuition reimbursement, and even help with student loans are now amongst the perks being offered to new employees.

While vacation and bonuses are nice, they are ultimately fleeting perks. Vacations end, bonuses are spent, and the wheels of business keep on turning. A slice of the company’s equity is a way to compensate employees who invest their time and energy toward company goals. Equity award benefits are popular in compensation packages because they entice workers to care about the performance of the firm. Employees are more willing to go the extra mile when they know they’ll get a piece of the pie.

From both an employer and employee perspective not all equity and stock options are the same. It’s crucial to know the difference so you can avoid unnecessary taxes and maximize your potential income.

Chapter 1

Employee Equity Award Benefits

Chapter 2

Other Equity Awards

Chapter 3

Exercising Stock Options – Timing and Taxation

Chapter 4

Equity Award Vesting and Taxation

Chapter 5

Planning for Disposition of Employer Stock

Chapter 1

Employee Equity Award Benefits

An equity benefit package isn’t simply throwing a few shares of stock at employees. Different types of stock options vest according to different parameters, which could be based on performance, length of employment, or other types of incentives.

A bonus is just a check in a bank account, but a stock option needs a custodian and some tax planning to make sure the beneficiary gets the most bang for their buck. Here are some of the most common types of equity benefits.

Stock Options

Stock options are the most common type of equity compensation awarded to employees. Like the types of stock options you see traded on exchanges, employee stock options also come with a predetermined exercise price, like a strike price.
What are Stock Options and How Do They Work?

To entice new hires to stick around (especially at startups where other compensation is often scattershot), the awarded stock options may have a ‘vesting’ schedule that requires employees to work a certain amount of time at the company before the full allotment of options can be exercised. In some cases, employees may have the right to exercise a portion of their options immediately.

For example, Amazon (NYSE: AMZN) may offer new hires a stock option that vests in 24 months. After two years on the job, the employee’s stock option ‘vests’ and they have the choice to buy shares at the discounted price from two years ago. Stock options may also carry an expiration date, so employees must choose to exercise or allow the option to expire.

Employee stock options fall into one of two categories:

Incentive Stock Options (ISOs)

ISOs have not been common in recent years due to an accounting change in the corporate deduction for these types of stock options.

ISOs can only be issued to qualified employees, but all employees do not need to be eligible to receive them. In fact, ISOs are often only distributed to select, high-ranking employees.

ISOs expire after 10 years, which provides beneficiaries plenty of time to exercise. ISOs also receive favorable tax treatment. If held at least two years from the grant date and one year from the exercise date, ISO profits are taxed at the capital gains tax rate. However, you may have to pay Alternative Minimum Tax (AMT) when you exercise.

Planning for ISOs is complex due to the AMT. If you do pay AMT upon exercise you can possibly receive the AMT paid back when you sell the shares. Caution: If you pay AMT and the stock later loses value or becomes worthless you will not receive your AMT back. You will not receive a break from the IRS for the AMT paid which cannot be recovered. The IRS’s position is that you speculated on the future value of the stock and there is no relief in the tax code for investment speculation.

Unfortunately we saw this first hand when we used to prepare taxes. Where our Andover, Massachusetts office is close to Boston and the 128 technology belt, we work with a lot of people in the high tech industry. In the roaring late 90’s there were numerous high tech start ups which went bust in the early 2000’s. My point is that planning with ISOs is complex. You should consult with your CPA or a financial advisor that is very knowledgeable about these types of stock options.

Please note that if ISOs are exercised and immediately sold (cashless exercise) or sold before they are held for a year, they become disqualified and are treated the same as Non-Qualified Stock Options.

Non-Qualified Stock Options (NQSOs)

Non-qualified stock options are currently the most common type of stock options awarded. They give the recipient the right to purchase a stated number of shares of company stock in the future at a preset price (which is typically the market value of the shares at the date of the grant.) The recipient has a window of opportunity to exercise and acquire the shares between when the option vests and when it expires. The expectation is that the stock price will increase over time and the recipient will be rewarded by being able to acquire the shares at a discounted price.

Chapter 2

Other Equity Awards

Stock options aren’t the only method for awarding equity to employees. Following are some additional forms of equity compensation.

Restricted Stock Awards (RSAs)

Company stock that an employee receives generally at no cost. The shares are typically subject to a vesting schedule. Once the employee receives the award the shares are owned. Where the shares are owned, if subject to vesting the employee can make an irrevocable IRC Section 83(b) election within 30 days after they receive the award.

An 83(b) election can be a powerful tax planning tool. If the value of the shares are low when the award is made you can elect to pay taxes at the low value even though the shares have not vested. If the subsequent sale of the shares is after one year then any appreciation is taxed at the lower capital gains tax rate (lower as of the date of this article – taxed from 0% to a maximum of 20% excluding the Medicare Surtax).

Caution: You must make and send the 83(b) election to the IRS within 30 days of receipt of the award AND any taxes paid will not be refunded if the stock does not vest or appreciate.

Restricted Stock Units (RSUs)

RSUs are currently the most common type of equity award. They are a promise from the employer to grant company shares to their employees at a future date (or series of dates). RSUs typically vest over a period of time. Some awards may be contingent on meeting specific performance marks (Performance Shares noted below). Unlike RSAs, RSUs don’t convey any stock ownership to the employee until vested. Therefore, RSU beneficiaries have no voting rights in the company shares until vested and the stock is owned. RSUs can be paid in either stock or cash.

Types of Restricted Stock Units

Performance Share Units (PSUs)

Performance Share Units (PSUs) offer the promise of company shares provided certain prerequisites are met. While an a RSU’s grant results in the award of a specified number of shares upon vesting, the number of shares awarded upon vesting of a PSU grant will vary. If the specified performance-based initiative (achieving an earnings landmark, hitting a company growth milestone, etc.) is not met, the recipient may receive a reduced award or no reward at all. Similarly, the plan may allow for a multiple of the original shares grant if performance exceeds the goal that was established.

Total Shareholder Return Units (TSRUs)

Total Shareholder Return Units (TSRUs) are RSUs that are meant to reward the recipient with stock or cash equivalent to the increase in value that would have been realized had the recipient owned shares outright during the period between when the grant was awarded and when it was settled — hence the name “total shareholder return” unit.. An employee awarded TSRUs will receive the increase in value of the stock between the grant and vest date and also any dividends declared between those two dates.

Employee Stock Purchase Plan (ESPP)

Here’s one that’s a little different. An Employee Stock Purchase Plan (ESPP) is an employer- administered program that offers shares of company stock to eligible employees at a deep discount (up to 15%) to the current market value. Employees contribute through payroll deductions during the offering period. The withheld funds are used to purchase shares at the discounted price.

Most employer plans are Qualified Plans under IRC Section 423. This allows for preferential tax treatment. With a qualified plan if you sell one year after the purchase date and two years after the grant date, you will receive preferential capital gain tax treatment. The gain or loss is the difference between the sale price and the price paid when you purchased the stock at a discount.

Employee Stock Ownership Plan (ESOP)

Employee Stock Ownership Plans (ESOPs) are not common for smaller employers with a limited number of employees. The idea is to create a market for the shares of a closely held company to buy out departing shareholders, a succession plan. In addition they reward employees by offering them a slice of company ownership. Under an ESOP, the shares of stock earmarked for employees are held in a trust. Once certain stipulations are met (or the employee retires), the shares designated for the employee will be repurchased by the firm and the employee will be awarded the cash compensation.

ESOPs are costly for an employer to set up but often have no upfront costs for employees, but they lose flexibility compared to other types of equity compensation plans. Fired employees will only be eligible for cash compensation equal to the number of shares vested at the time of dismissal.

Chapter 3

Exercising Stock Options – Timing and Taxation

If you are the recipient of a stock option award, you will need to decide if and when you will exercise your option and what you will do with the shares once an option is exercised – sell or hold. A lot of factors may come into play such as current market conditions, your cash flow needs, and your need to diversify. There are also tax consequences to exercising a stock option and disposing of the shares acquired.

Be sure to consult with your CPA or a financial advisor that is knowledgeable about stock options, to determine the best course of action.

When should you exercise your option? Should you take the cash equivalent or put the shares in a brokerage account? Each of these decisions will impact your tax obligations for the year, so double-check with your advisor and make sure that you aren’t paying the IRS more than it deserves.

Chapter 4

Equity Award Vesting and Taxation

Other equity awards like RSUs work a little differently. An employee receives a grant that vests over a period of time after which the shares are automatically awarded. Typically, no taxes are owed when the grant is received by the employee. Instead, taxable income is recognized when the equity award vests. The market value of the vested shares is treated as compensation income to the employee and taxed at ordinary income tax rates. Your employer will typically withhold some shares to cover the income and employment taxes due and will distribute the remaining shares to you.

Any increase in value after the shares vest will be a taxable gain. If you hold the shares for at least one year after vesting, the gain on sale will be taxed at the more favorable capital gains tax rates.

Chapter 5

Planning for Disposition of Employer Stock

Tax planning is an important part of any financial strategy – even more so when your compensation package includes equity awards.

You will want to work closely with a knowledgeable financial advisor or tax accountant so the tax considerations can be factored into your decision-making. Not all stock and equity options are treated the same way by the IRS so you will want to have some expert  guidance to help you preserve the value of your slice of the pie.

The tax considerations are important but don’t let the tax tail wag the economic dog! A common error that we see is that employees base too much of their decision on the tax implications of exercising and/or selling the stock. For example; if you hold a stock longer than you planned or was appropriate based on the value or the momentum of the stock, and the stock loses $1 of value per share, you lost 60 to 75 cents on the dollar. Compare this to selling when appropriate, when the stock was at the $1 higher price, and only losing 25 to 40 cents in taxes. You keep a majority of the $1 higher price. The point is that the economics of the situation are more important than the tax hit.

Like all investing you want to have a plan and stick to it. All stocks trade within a range which provides good insight into when to sell the shares that were planned to sell. Your advisor can help you stick to a disciplined plan. When you work for a company and believe in their future, it is easy to not pull the trigger on exercising and/or selling shares.

Bartley Financial is built around a client-first ethos. We are as committed to exhibiting high levels of professionalism as we are to building relationships with clients built on trust and mutual respect. That’s why we hold ourselves to a fiduciary standard. It’s also why we offer a transparent, fee-only compensation structure so that our clients never need to be concerned about a conflict of interest.

Bartley Financial has an experienced team of CPAs and CFPs® (Certified Financial Planners®) that help clients manage their investment portfolios, plan for retirement, strategize taxes, or execute any other initiatives in pursuit of optimum financial health and minimal financial stress. From our offices in Andover, MA, and Bedford, NH, we work to ease clients’ financial concerns, strengthen their portfolios, and assuage their worry that they don’t know what they don’t know.

Contact us today to begin a relationship with a team of knowledgeable, trustworthy professionals who put their clients first.