Managing Your Equity Compensation

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. Below we discuss the following:

• How the different types of compensation vary by taxation and form of ownership

• The risks embedded in stock based compensation including concentration risk and tax liability risk

• The behavioral biases that are common with individuals holding concentrated positions and/or company stock

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, narrow the range of potential portfolio outcomes, and improve your chances of achieving investment success.

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 some shares. For instance, since RSUs are taxed when they vest, selling soon after vesting allows you to withhold cash for taxes and diversify your holdings without triggering much of an incremental tax liability. A downside scenario that should be avoided involves not selling RSUs to cover your tax liability, owing tax on the vested value, and watching the stock suffer a large drawdown. In that scenario, the employee then owes tax on the vested value but is now holding the shares at a much lower value.

As it relates to options, we have detailed how exercising can create a taxable event. Another important detail to keep in mind is the expiration date of your options and what could happen if you leave the company while you have unexercised options. Option grants often have 10 year windows and, if you haven't exercised any options along the way, you may be in for a big tax hit in year 10. When it comes to ISOs, it can make sense to exercise a portion of your options each year in a tax-conscious manner to avoid having to exercise them all in the last year of your grant window. This can also come into play upon change of employment, whether voluntary or involuntary, as there is typically a 90-day window to exercise vested options after an employee leaves a company. Decision making around annual exercises needs to take into account the total number of vested options, the time until expiration, the difference between the exercise price and the fair market value of the stock, and your current tax situation. If the shares have appreciated greatly, exercising all of your options in the final year, or in the year of employment change, can come with big tax implications.

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. With multiple grants, strike prices, vesting schedules, and compensation types, equity awards can be difficult to keep track of. Figuring out which grants to exercise or which shares to sell requires a solid understanding of the many factors which we have already discussed. Behaviorally, it can be difficult for employees to make decisions around when to sell shares and diversify given their belief in the company's future and the effects of behavioral biases such as the endowment effect, regret aversion, anchoring bias, availability bias, and status quo bias.

• The Endowment Effect: Valuing something you own more highly than you would if you didn't already own it. In this case, placing a higher value on your company's shares than if you were an outside investor considering buying the stock.

• Regret Aversion: Avoiding acting or making a decision for fear of later regretting it. Many individuals are reluctant to sell shares of company stock for fear that the stock might continue to go up in price. This can prevent individuals from making rational decisions around diversification and risk.

• Anchoring Bias: Relying on an initial piece of information when making future decisions. After a stock hits a high price, individuals may focus on that price as the benchmark for future sales saying "I'll sell once it gets back to X".

• Availability Bias: This bias refers to the tendency of people to rely on information that comes readily to mind, possibly overstating the probability of a similar event occurring. When it comes to concentrated stock positions, this may relate to an individual expecting their own company stock to substantially increase in value because of the success of the company stock held by a friend or peer in a similar industry.

• Status Quo Bias: The tendency for people to prefer the current state of affairs over a change, even if that change might be beneficial. Under this bias, individuals may be reluctant to take necessary actions to improve the diversification of their investments because, in the current state, their company stock is performing well.

  
  

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. Employees who relay on their sense of how the company is doing or how they think the stock is likely to perform run the risk of making emotional decisions. Developing a plan that considers one's overall asset allocation, tax situation, type of equity compensation, and unique financial goals is the path to success when dealing with equity compensation.

Working with a financial advisor and tax professional can take some of the burden off your shoulders and help you to achieve successful, 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.

508-830-4778

kjohnston@1620ia.com