The term equity compensation is a fancy way of saying that an employee receives some form of ownership (also known as equity) in their company as a part of their payment and benefits (i.e., the compensation package). Typically, this will be just one component of how an employer compensates an employee for his or her work — it can be included on top of salary, healthcare benefits, 401(k) match, and other perks.
If you receive any sort of stock or stock options from your employer, then you should make sure to understand precisely how this benefit works and how it fits into your unique financial situation. Some types of equity compensation may include, but are not limited to, the following:
- Restricted Stock Units (RSUs)
- Restricted Stock Awards (RSAs)
- Employee Stock Purchase Plans (ESPPs)
- Incentive Stock Options (ISOs)
- Non-Qualified Stock Options (NQSOs or NSOs)
Employee Stock Options
Receiving stock (or options to buy stock — more on that later) in your company can be much more complicated than receiving a paycheck. For starters, you cannot take your company stock and buy groceries with it. You would have to sell it first. With this prospect, a number of questions arise:
Is it even possible to sell my company’s stock? Should I sell it? If so, how much and when should it be sold?
Do the taxes work the same as with other stocks in my investment accounts?
As with so many questions in financial planning, the answer to these questions usually is: it depends.
One major factor is whether someone works for a company that is owned privately (not actively traded on the open market) or publicly (i.e., traded on a major stock exchange — think Apple, Google, etc.). Private companies often have very limited opportunities, if any, for employees to sell their shares, especially in the near-term. Public companies allow greater flexibility for employees, but there still may be resale restrictions depending on the type of equity one receives, vesting requirements, your position in the company, and other restrictions outlined in the plan document and grant agreements.
Assuming that someone is fully vested in their employer stock and has a market to sell the shares, they should consider if or how much to sell. The risk of not selling any shares is possibly accumulating an investment portfolio where funds are highly concentrated in one company. While an employee-owner may have a strong outlook for the company, this concentration poses a risk nonetheless. In the worst-case-scenario, an individual’s company goes out of business. It that situation the employee-owner not only would lose their job, but they would also lose their investment savings (those savings in company stock) that were meant to go toward funding retirement, traveling the world, paying for a child’s college expenses, or buying a new home.
Being proactive and making a plan for your company stock will allow you to take advantage of your company’s equity compensation plan while reducing the risk of having too much of your savings in one company.
Planning ahead will also help a you know what to expect on taxes and potentially reduce your overall tax bill.
Incentive Stock Options and Non-Qualified Stock Options
Did you know that there is different tax treatment depending on whether you exercise Incentive Stock Options (ISOs) versus Non-Qualified Stock Options (NQSOs or NSOs)?
Further, if one exercises ISOs and later sells the stock, there can be different tax consequences depending on the timeline of when the stock options were granted, when the options were exercised, and when the shares were sold. Importantly, if one exercises ISOs, they may owe income tax even if they do not sell the stock and did not receive any cash inflows! This income recognition is incurred under the rules of the Alternative Minimum Tax (AMT) system.
For example, one individual we worked with exercised enough ISOs to increase his company stock ownership by several hundred thousand dollars on top of the $1 million or more that he already held. This was a publicly traded company and the ISOs were exercised in the beginning of the calendar year when the stock price was very high relative to the exercise price of the options (i.e., what the ISO holder pays to acquire actual shares of the company). This large spread (between the stock price at exercise and the exercise price itself) would be subject to taxation under the Alternative Minimum Tax if the shares were held through the end of the year. We helped this client understand the different tax treatment of two courses of action:
- holding the shares long enough to meet the holding period requirement for capital gains tax treatment — this would have incurred a higher tax bill on the AMT component but also gets favorable tax treatment (capital gains) on the gain at sale later on; or
- selling the shares during the same calendar year in which they were exercised — this is a “disqualifying disposition” which means you are subject to ordinary income tax on the gain at sale but it also reduces the AMT component if (and this is a very important “if”) the stock price has decreased since the options were exercised.
The tax bills resulting from the two paths above can have a difference amounting to tens of thousands of dollars or more. Further, there is the subject of liquidity to consider in each of the two paths. Course A (holding the shares longer) led to incurring a tax liability before the shares were sold, meaning this individual needed to have enough cash on hand to pay the tax bill. Course B involved selling the shares, meaning some of those proceeds could be used to pay the tax bill as needed.
Growing Your Wealth
In addition to assessing the timing and tax implications of selling stock from ISOs, we helped this client determine an appropriate investment allocation for long-term growth. Using the proceeds from the sale of company stock, he was able to invest in a diversified portfolio which significantly reduced the risk in his investment savings.
Equity compensation is an exceptional way for companies to attract top talent and for employees to be even more invested (pardon the pun) in their work. The point is not to convince people to hastily sell all of their company stock, but rather to encourage them to take a close look at how their company stock fits into the big picture of their financial and personal life. I encourage people to be proactive and understand the tax implications of selling company stock, determine how much company stock they should hold (i.e., when to start selling), and manage the risk in their investments to improve the chances of reaching their goals.
