Granting stock options or shares of stock to employees is a common method of compensation for many companies, especially those in the software and technology sectors. Such compensation is enticing to both employers and employees as it can be an important retention tool while giving employees the opportunity to participate in the company’s upside. Receiving options and/or shares is not as simple as receiving cash compensation. Understanding the different types of stock compensation and the accompanying tax and risk implications can become quite complicated.
Common Types of Compensation:
Non-Qualified Stock Options (NQSOs): NQSOs give the employee the right to purchase shares of the company stock at a predetermined price before an expiration date. When NQSOs are exercised and the shares are acquired, it is a taxable event. The difference between the price paid for the shares and the fair market value of the shares when they are acquired is treated as ordinary income.
Incentive Stock Options (ISO’s): ISOs are similar to NQSOs in that they provide the right to purchase shares at a predetermined price. They differ from NQSOs in that it is not necessarily a taxable event when they are exercised. When ISOs are exercised, the difference between the fair market value of the shares and the price paid for the shares will be used to calculate the Alternative Minimum Tax on the individual’s tax return. If the amount is large, it may trigger a tax liability.
Restricted Stock Units (RSUs): Rather than an option, RSUs are actual shares of stock given to the employee as compensation. When RSUs vest and are delivered to you, the value is treated as ordinary income. Any change in value from that point on will be treated as a capital gain/loss when sold.
Managing Equity Compensations: Tax and Risk Implications
Risk comes largely in the form of having much of your investable wealth tied to the shares of one company, especially since that company is your employer who is also responsible for your salary. According to JP Morgan research covering the period 1980-2020 (JPM Research), over 40% of all stocks in the Russell 3000 U.S. Stock Index suffered a drawdown of at least 70% from which the stock never recovered (“catastrophic loss”). In addition, 42% of all stocks had negative absolute returns and 66% underperformed the overall market. The Technology sector exhibited the worst statistics as 54% had negative absolute returns, 59% suffered a “catastrophic loss”, and 73% underperformed the overall market. Diversifying your stock holdings away from your equity compensation can help mitigate long-term loss of capital and improve your chances of achieving successful investment outcomes.
On the tax side, it is important to understand the implications of RSU vesting and option exercising. When you are forced to pay taxes regardless of your subsequent actions, it can be wise to sell shares. For instance, since RSUs are taxed when they vest, selling soon after vesting allows you to diversify your holdings without triggering much of an incremental tax liability. A downside scenario that should be avoided involves not selling RSUs, owing tax on the vesting value, and watching the stock suffer a large drawdown. In that scenario, the employee then owes tax on the vesting value but is now holding the shares at a much lower value.
Lastly, managing equity compensation and the ensuing concentrated stock positions can be a burdensome task for employees. It can be both time consuming and emotionally draining. Behaviorally, it can be difficult for employees to make decisions around when to sell shares and diversify given belief in the company and the effects of behavioral biases such as the endowment effect, regret aversion, anchoring bias, and status quo bias. The best way to deal with making decisions is to develop a plan for the vesting and exercising of options and/or shares that revolves around a systematic process rather than a feel for how the company is doing or how the stock is valued/likely to perform. This can be done by considering one's overall asset allocation, tax situation, type of equity compensation, and unique financial goals.
Managing and developing a plan for your equity compensation is a complicated task. Working with a financial advisor and tax professional can take some of the burden off your shoulders and help you to achieve positive tax-efficient investment outcomes. If you are dealing with equity compensation and feel that you could use a helping hand, feel free to reach out to us at 1620 Investment Advisors to learn about how we advise our clients on such matters.
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kjohnston@1620ia.com