Financial Planning for Equity Compensation

One of the most common forms of life-changing sudden wealth is through stock options. If you work for a tech company or startup, you’ve likely been offered employee stock options as an employment incentive. If you are accepting employee stock options as part of your compensation package, it’s critical that you understand what they are and how you might exercise or sell them in the future. The tax and legal issues around stock options can be complex. A client’s stock options can represent 80% to 90% of their net worth, but if they are unvested or unexercised, extracting this value takes a great deal of planning. We have a team of professionals who have been helping clients get the most value when their company goes public through an IPO or SPAC.

Among other considerations, you’ll want to evaluate when you should exercise stock options, the tax impact of awards, how to determine and track the cost basis of stock, and whether and when to sell company shares. You’ll also want to understand big-picture concerns, such as how your stock-based compensation and other employer benefits will impact your financial future, including your retirement and estate planning.

We help companies, founders, corporate executives, and others with stock-based compensation learn more about their employee stock option choices and properly plan around them, leveraging opportunities to reduce the associated tax consequences. For employee groups, we also offer education tailored to your company’s specific stock plan and one-on-one planning to help executives navigate the tax complexities unique to their personal situation.

• Set Goals and Develop An Overall Plan: In granting you stock options or restricted stock, or the right to buy shares in an employee stock purchase plan, your company has given you what it hopes is a powerful motivation and retention tool. It wants you to understand the options’ value and fit the stock into your overall plans. All financial planning should start with setting goals. What do you want to do with the proceeds from the eventual sale of the stock? Pay for the kitchen renovations in two years, Hilary’s college in four years, Greg’s wedding in 12 years, or retirement in 35 years? Reflecting on this will help you focus on your specific use of the stock in relation to your other income and savings. Determine how you will handle the stock options over time. Remain aware of your choices, the term of your options, and the tax and lost-gains consequences of your exercise decisions. You need to exercise and sell at least enough stock to meet your goals. In addition, you may want to stagger the exercises and subsequent sales over a period of years to spread out the taxes. Alternatively, some studies have shown that holding options for the full term is the best way to maximize gains. If you simply decide at the beginning or end of each year whether or not to exercise and sell during the year, you may generate unnecessary taxes or lose opportunities when the price keeps rising. Plus, if you do not keep track of expiration dates, in-the-money options may expire unexercised.
• Accurately Value Your Stock Options: The intricacies of option taxation can easily catch you by surprise. You may forget to discount the value of the stock option by either the exercise price or taxes. The option to buy at $50 per share 1,000 shares of your company’s stock now trading at $100 may first appear to be the equivalent of a $100,000 investment (1,000 shares x $100 current price). However, in the end you may net only about $30,000 after paying the $50 exercise price and 40% in federal and state taxes combined. With the commonly granted nonqualified stock options (NQSOs), your company will probably withhold 25% federal taxes plus payroll and state taxes when you exercise your options.
• Wait As Long As Possible To Exercise: If the outlook for your company is good, don’t immediately exercise the options. A traditional stock option gives you the right to buy stock up to 10 years in the future. Historically, stocks increase in value over time. By waiting, you enjoy all the upside leverage potential without any cash investment, and the spread between your exercise price and the rising stock price grows without taxation. You should wait to exercise only if doing so meets your goals and needs. Should the stock options represent more than 25% of your net worth, diversification may be more important than waiting. In addition, your company may have stock ownership guidelines, or may just want to see you put more of your money at real risk in company stock, which would require you to exercise and hold the shares. Finally, if your company’s stock is volatile, making the price swings personally hard to tolerate, you may want to exercise and sell earlier.
• Learn What Happens When You Leave Your Company, AND Tell Family Members: Read the option plan and your grant agreement carefully. Know your rights if you are fired or if you quit, work for a competitor, retire, become disabled, or die. Many plans give you no more than 90 days to exercise vested options after job termination for retirement or disability, though the post-termination exercise period can be longer. However, you may lose vested options immediately if you leave the company to work for a direct competitor. Make sure you, as well as your family or close friends, are aware of these rights.
• Focus On Vesting Rules And Dividends: Some companies now grant options that are immediately exercisable but have resale restrictions that lapse over time. You will need to put up the cash to exercise and hold the shares after exercise, a strategy that may be attractive in pre-IPO companies where you expect a big price run-up. If you make a Section 83(b) form filing with the IRS within 30 days of exercise, you pay tax at ordinary income rates on the spread at exercise for NQSOs (for ISOs, the spread is part of your AMT calculation), then the gains at sale will be taxed at capital gains rates. Similarly, if your company’s stock pays a dividend, you may be better off exercising now and holding the stock to receive the dividend. This remains true even if you must borrow to buy the stock. You will end up ahead when the dividend generates more cash than the cost of borrowing.
• Determine Tax Rates And Watch Brackets: Most stock options generate ordinary taxable income when exercised, either because they are NQSOs or because the ISO stock is immediately sold after exercise. Determine your tax rate so that you can plan for any estimated tax payments and analyze whether you want to take all the income in one year or spread it out over several years. Supplemental income includes compensation from exercises of NQSOs and SARs and from restricted stock vesting (not ISO exercises or ESPP purchases), along with bonuses, commissions, overtime pay, and severance pay. For federal purposes, income tax is withheld from supplemental wages at a flat 22% rate (but 37% for amounts of aggregate supplemental income in excess of $1 million during a calendar year). Supplemental income is also subject to Social Security, Medicare, and FUTA taxes. Each state has different rules on what type of income is considered supplemental wages and what tax rate, if any, applies.
• If You Have ISOs, Learn About AMT: First, before you decide to exercise and hold the stock, double-check whether you have incentive stock options (ISOs) or nonqualified stock options (NQSOs). With NQSOs, when you exercise, you will owe tax at your ordinary income rate on the spread between the option exercise and market price whether or not you immediately sell the stock. However, with ISOs, when you intend to hold the stock for one year to qualify for capital gains tax treatment, you face a tax trap. The biggest mistake you can make with ISOs is to forget or not know about the alternative minimum tax (AMT). The AMT rules require you to include the spread on exercise of ISOs in a calculation of alternative income, unless you sell the shares in the calendar year of the exercise. The messy AMT calculation adds back to your income a number of standard deductions (e.g. state and local taxes). It then multiplies this amount by 26% or 28%, according to the amount of your AMT income. Should the tax on this amount be higher than under the standard rules, you pay the higher amount instead. A Form 3921 is sent to you by your employer for any year during which you exercised Incentive Stock Options. The numbers reported on Form 3921 allow you to calculate the additional income that is included when calculating your AMT tax liability. If you owe the alternative minimum tax (AMT) because of an incentive stock option (ISO) exercise, all or part of the excess of the amount of your AMT liability over your regular-tax liability for that year can generate a tax credit. It is applied against your regular taxes in one or more later years. The calculation, made on IRS Form 8801, is not simple and requires a tax professional. If you are eligible for a tax credit that results from the exercise of your ISOs, that credit may be applied directly against your tax liability in years in which your regular-tax liability exceeds your AMT liability. The balance of the credit carries forward and may be used in subsequent years.

Even if you’re already familiar with stock-based compensation and its tax implications, contact a trusted advisor for help identifying new opportunities, weighing possible tax scenarios, and fitting your stock-based compensation planning into your larger financial goals.