Taxes and Stock Options; Moving Forward Mindfully
May 12, 2021
Now that we’ve discussed the different types of stock option plans available to employees, it’s time to take a dive into how to leverage those options, striving to preserve wealth as best as possible. As per my last post, there are three main categories of stock options: Restricted Stock Units (RSU), Non-qualified Stock Options (NSO) and Incentive Stock Options (ISO). Each are offered to the employee with different levels of monetary commitment, and thus have different ways to handle them from a tax and general portfolio perspective. Much of this article will be written about ISOs, as there are different tax vehicles one can leverage to mitigate tax risks and help diversify a portfolio over the long-term.
But I don’t want to totally ignore the RSU and NSOs. RSUs are taxed as income when they vest, at the state and federal level. When these grants vest, the fair market value of the stock less any consideration paid for the grant is a part of an employee’s compensation with payroll taxes withheld by the company. The employee can then decide to deposit the remaining shares into a brokerage account, or sell the shares to diversify the holding. This process is pretty straightforward and automatic, and not a lot of planning needs to be done.
NSOs take a bit more thought. These are discounted shares that the employee can purchase, and the difference between the ‘strike’ price and the market value is taxed as compensation income by the company. Typically, an employee will sell the shares immediately upon purchase to reserve cash to pay upwards of 30-40% in federal and state income taxes. That said, an employee can defer exercising these options for up to 10 years. Employees will want to exercise options prior to their expiration date – which is typically 10 years after the grant date. The taxes are only incurred after the option shares are purchased; the employee does not have to sell or buy the stock if it does not make sense economically.
So far, pretty straightforward. Now we get to the ISOs, and the tax structure and long-term strategies can get more complex. The government likes to get paid – especially by those who can afford it. Many, many moons ago, way back in the 1960s, the IRS came up with the idea of the Alternative Minimum Tax (AMT) to create a ‘floor’ of how much tax individuals and couples will pay after hitting certain income thresholds. Depending on how their taxes flesh out, individuals (or couples filing jointly) will pay either their regular taxes OR the AMT calculation.
ISOs, when exercised, are not reported by the employee as income. They are handled under the AMT tax structure, separate from regular income. When an employee purchases ISO stock, there is an AMT adjustment that happens at the time of that purchase. This AMT adjustment can cause the taxpayer to be subject to AMT tax at a rate of 28%. If the holding period requirements are met, the eventual sale of the stock at a gain is eligible for preferential long-term capital gain treatment, versus the 30-40% associated with ordinary income tax. The AMT adjustment amount is reversed in the year you sell the stock. For ISO stock option holders, a multi-year strategy should be prepared to optimize the amount of options to exercise and sell annually, while minimizing the AMT tax hit.
ISOs can also be handled a bit differently if an employee has a large concentration in a specific company stock but does not want to incur the tax from a sale in order to diversify stock holdings. Employees can strategically diversify their stock options by placing their concentrated purchase of ISOs into an exchange fund. This exchange fund is typically held with a bunch of different companies’ stock, and after a specific timeframe, the employee can withdraw from the exchange fund with a diversified pool of stocks from the fund. This diversifies a portfolio over the long-term without the tax hits associated with buying and selling individual stocks on the retail market.
Another strategy that can be employed with large concentrations of company stock is writing call options against the stock position. This strategy allows the holder of the call to buy your stock at a fixed (strike) price within a specified period. The holder of this option pays you a premium for this right. This strategy allows you to collect a premium in addition to the price you are willing to sell it at, if the option is exercised. The risk is your stock sales price is fixed under the terms of the option agreement. If the underlying stock is trading at a higher price than your option’s strike price, the holder of the option will exercise and you will lose out on the difference. Call options generally are layered over multiple periods and are often just one component of a sales strategy to diversify.
Strategies for diversifying portfolios and tax mitigation over the long-term for all stock option plans can be a full-time job. Not understanding all the risks involved can paralyze employees into not taking action at all, which could have its own implications on a portfolio over the long-term. Speaking with a trusted advisor in advance of a stock event can help empower employees to make sound investing decisions, while mitigating pitfalls of overconcentration, tax mitigation, or leaving money on the table that could be working for investors. I work with many clients that have these types of stock considerations and am happy to speak with you about your individual needs now, and into the future. Call me today to discuss! We can work together to help you optimize your wealth and tax planning over the long-term. Contact me at Vince.Lee@Coldstream.com.
CIRCULAR 230 NOTICE: Disclosure: To ensure compliance with requirements imposed by the IRS, we inform you that any federal tax advice contained in this communication (including attachments) is not intended or written to be used and cannot be used for (1) avoiding penalties imposed under the Internal Revenue Code or (2) promoting, marketing or recommending to another party any transaction or matter addressed herein unless the communication contains explicit language that it is a tax opinion in compliance with IRS requirements. Please contact your tax advisor for guidance on your individual situation.