Understanding the Tax Implications of Company Stock Compensation
What You Need to Know About Three Common Types of Equity Compensation
Many large companies now offer their executives company stock as a form of compensation. Stock compensation can make for a fantastic opportunity to build wealth, but it’s important to understand exactly what it means. There are both risks and tax implications to consider, which may vary depending upon the type of stock compensation you’re given. Below we’ll discuss the three most common forms of equity compensation – that is, non-cash pay – and review the implications of each.
Essentially, a stock option gives you the right to purchase a set number of shares – at an established price – after a certain amount of time has passed, referred to as vesting. Many companies use stock options as a retention tool, with the hope that the stock will appreciate by the time vesting occurs, thereby creating a lower purchase price relative to the prevailing stock price.
If you’ve been granted Non-Qualified Stock Options (NQSOs), this price difference is called the bargain element, and it is taxable as ordinary income in the year you choose to exercise your options. All ordinary income is subject to Social Security, Medicare, and payroll taxes. If you so choose, you can elect a cashless exercise, wherein you buy and sell the stock at the same time. If you buy and hold the stock for less than one year, you will have either a short-term gain or loss, whereas holding it for longer than a year creates a long-term gain or loss.
If your employer has granted you Incentive Stock Options (ISOs), you have a useful tax advantage. This is because you report income only when you sell the stock, rather than at exercise. Your tax rate will depend on how long you hold the stock. Typically, waiting a year from purchase (exercise date) and two years from when the options were granted, any profit you might receive on the sale is treated as a long-term capital gain. This scenario could spell significant savings over being taxed at ordinary income tax rates.
Note that you are required to report the bargain element in the year if exercise for purposes of the Alternative Minimum Tax (AMT) unless you sell the stock in the same year. Later, when the stock is sold, an AMT adjustment is made. This is best done with the guidance of a qualified tax professional.
Another common form of equity compensation is Restricted Stock Units (RSUs). With restricted stock, you are granted a certain number of shares that become vested after a particular period of time has elapsed.
RSUs act as a company promise to grant shares, and they do not constitute actual voting stock until they vest. Sometimes, you can elect to receive cash at vesting instead of stock. Like NQSOs, RSUs are taxed as ordinary income on the date they vest based on the market value of your shares. If they are held beyond vesting, short- or long-term capital gains are realized upon the final sale – and this is in addition to the tax due at vesting.
A similar form of equity compensation is the Restricted Stock Award (RSA). Once granted, RSAs are owned by you the employee. Unlike RSUs, however, they are not redeemable for cash. Their tax treatment is also disparate. If the company makes an 83(b) election, choosing to pay taxes on the fair market value of the restricted stock at the time of granting, you can choose to pay the ordinary income tax at the grant date instead of the vesting date. This gives you more control over the timing of the tax payment, which is helpful if you’re trying to coordinate bonuses or other income sources, too. If the company does not make an 83(b) election, however, your tax payment is due at vesting, as with RSUs.
Stock Appreciation Rights
Employers may also grant employees Stock Appreciation Rights (SARs), which share many similarities with NQSOs. Income tax payments are not due until exercise, meaning you can choose to exercise them at the most opportune time. The formula used to calculate the value of SARs is this: calculate the difference between the grant price and the exercise price, then multiply it by the number of shares.
SARs are also similar to RSUs because the taxes can be paid in cash or by withholding shares. Electing to withhold shares simply means you end up with fewer shares after the initial exercise of your rights.
SEE ALSO: Lessons in Behavioral Investing
Considerations for Company Stock Compensation
Investing in company stock certainly has the potential to increase your net worth. However, exercise caution by not letting it become too large a portion of your overall portfolio. Many savvy investors follow the rule of limiting their exposure in any single company to 10 percent of their overall portfolios. This is an especially smart rule to follow if your job, insurance, and paycheck are all tied to the relative success or failure of the company you work for.
If you’d like to discuss the tax implications of your particular portfolio, please reach out so we can begin a conversation. At Charles Carroll Financial Partners, we are committed to providing personalized investment management and financial planning to help you meet your needs, goals, and aspirations.