Insights

March 9, 2022

Stock Awards: A Tax & Planning Primer

In Employer-Provided Benefits, Financial Planning, Tax Planning, Wealth Strategy

Companies are always looking for relatively inexpensive ways to increase the odds of getting the best workforce to join them. In the Technology sector, these ‘inexpensive’ incentives often translate into offering employees stock awards. By offering workers this interesting ‘carrot,’ they offer ownership in the company in return for their tenure and a job well done. Companies who offer stock awards benefit in a few important ways: 1) it enables corporations to preserve cash, 2) it ties employee wealth directly to the success of the company, and perhaps most interesting, 3), tempting workers to take on the risk of working for a startup – especially with pre-IPO companies; stock options have been marketed well with breaking news headlines of employees hitting IPO jackpots.

These are all great things for the company, but what exactly do stock awards mean to you? Stock awards are often confusing and can vest over a long timeframe. If you are new to the stock award game, there is risk to your financial portfolio that isn’t as obvious as whether the company sinks or swims. You can mitigate your personal financial risk by learning more about the various stock awards offered by companies. We’ve put together a primer — outlining the different types of stock awards, how they work, how they are taxed, and how you can leverage these benefits as part of your financial plan.

STOCK AWARD TYPES – THE BIG THREE

1. Restricted Stock Units (RSU)

A restricted stock plan is a stock grant that comes with applied restrictions or limitations.  For example, a common restriction requires you to forfeit the shares if you terminate employment within a certain number of years. Typically, RSUs are granted at no cost – these are a bonus, and not something you need to purchase. The value of the RSU grant is not taxed until the units vest. Once the RSUs vest (restrictions lapse), you will be taxed on the value of the stock. The tax burden on this type of income can be high depending on your personal tax bracket and state income tax. RSUs are a great way to provide key employees with some kind of ownership without handing over immediate and unrestricted ownership.

2. Non-qualified Stock Options (NSO)

NSO stock options have a set purchase price (“strike price”) which doesn’t change regardless of how the stock is valued. This can be risky from an employee perspective, because if the stock declines in value, the cost to exercise the option could potentially exceed the value of the shares. In that case, the value of your options would be $0 while the shares remain “underwater.” Fortunately, stock options usually last for a long period of time (typically up to 10 years) and you do not have to sell or buy the stock if it doesn’t make sense economically. When NSO options are exercised, you will be taxed on the difference between the value of the stock and the “strike” or set purchase price. NSOs are taxed as regular income.

3. Incentive Stock Options (ISO)

ISOs are handled a bit differently from the other two stock awards. These are given preferential income tax treatment, which may change the way you hold or sell these types of options. Similar to NSOs, ISOs also come with a vesting schedule and strike price. When ISO options are exercised, you may be subject to Alternative Minimum Tax (AMT) on the difference between the value of the stock and the strike price. This can be a significant tax advantage as not all taxpayers are subject to this additional tax. It may be possible to exercise a small amount of shares that does not “trigger” the AMT tax. For optimal tax treatment, ISOs have a required holding period of one year from date of exercise and two years from the date the option is granted. If this required holding period is not met, ISO exercises will be taxed like NSOs.

PLANNING TIPS

How should you think about stock awards in the context of your financial plan? There are many strategies you can employ, but the key is having a clear picture of how the future value of stock grants can change, secure, or risk your financial future.  Understanding the potential tax ramifications and outlining a plan for diversifying your company stock will help ensure you are not caught off-guard by large tax bills or sudden declines in a company’s stock price. Here are a few key planning points to consider:

Restricted Stock Units (RSU)

Investment Planning – Holding the shares you receive upon vest should be approached as an investment decision. Ask yourself, if the company paid you an equivalent amount in cash, would you turn around and purchase shares of company stock with the income? If the answer is no, you may want to consider selling the vested shares and reassess where to redeploy the cash. Like any investment decision, you should consider how holding the stock fits in with your long-term plan. Having a gameplan in place prior to each vest date can help avoid many stumbling blocks, such as decision paralysis or making emotional decisions based on market conditions. Consider setting a target stock concentration and immediately sell any shares that exceed this target. A common, prudent rule of thumb is to avoid holding more than 10% of your overall portfolio in any one stock.

Tax Planning – The default withholding rate on RSUs is a flat 22% – and this is often the root cause of unexpected tax surprises. If you are in a tax bracket higher than 22%, you can cover the difference by selling additional shares and making an estimated tax payment. Better yet, if your employer allows you to adjust your withholding rate, bump up the tax withholding to your effective or marginal tax rate to avoid the hassle of quarterly estimated tax payments. Check with your CPA for the withholding % that would best cover your expected tax liability.

10b5-1 Planning – If you have already decided you want to sell shares upon vest, why not automate your plan?  Check with your employer’s legal department to see if you can utilize a 10b5-1 trading plan to facilitate the immediate and automatic sale of your shares upon vest. The use of a 10b5-1 trading plan is especially useful if you are subject to trading windows, or if you simply tend to get too busy. Your Coldstream wealth manager can often help facilitate the use of a 10b5-1 trading plan.

Stock Options

Planning Tip – A unique feature of stock options is the “leverage” they provide. With stock options, you have the opportunity to benefit from future price increases in your company stock without having any personal skin in the game. Additionally, you have control over the timing of the income realization (up to the expiration date of the options). This creates some interesting planning opportunities – such as matching the timing of your option exercises to lesser income years or realizing the income in years that you have higher deductions.

NSOs – Low on cash? A common strategy is to utilize a cashless transaction where you exercise and sell enough of the options to cover the full cost to exercise. You will receive the net proceeds that exceed the exercise cost, and most importantly, you do not need to deliver outside cash to complete the exercise of your shares.

ISOs – ISO planning strategies are possibly the most interesting and complex if you want to maximize the tax benefits that are unique to ISOs. You will want to work with an experienced financial planner and tax expert to ensure you execute these strategies to your full advantage. Watch for any years where you have “room” to exercise ISOs without incurring Alternative Minimum Tax. Careful consideration should also be given to your holding period. Typically, you want to hold ISOs for more than 1 year, but at times, it could become more advantageous to sell within 1 year to “disqualify” the ISO. The complexities go beyond the scope of this blog post, but please reach out to your wealth management team to discuss these strategies in more detail.

83(b) Elections – The 83(b) election accelerates the exercise and taxes due on your stock options. You might want to consider an 83(b) election if you can easily afford to exercise the options, and when the resulting taxable income would be extremely low. Paying ordinary income tax on a small amount of income can be beneficial if the company experiences huge future growth on the stock price. With an 83(b) election, the tax on your future gain is converted to the lower capital gains tax rate. You must remember to file your irrevocable 83(b) election within 30 days of being granted restricted shares or within 30 days of exercising your options early. There is very little time to act, so please be sure and alert your planning team immediately regarding any new stock grants.

Given the complexities and potential tax benefits of various stock grants, we recommend working with an experienced financial planner and tax expert to help determine the right strategy for you. Your Coldstream wealth management team is well-versed in planning around stock grants and the potential tax opportunities. Please reach out if you would like to discuss your unique situation.

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