Employees who receive long-term incentive compensation in the form of corporate equity benefits - such as RSUs, ESPPs, and options - may find themselves accumulating more shares than they know what to do with, or feel baffled by how to plan for the tax liability.
Because of this, you may be hesitant to either exercise your options or sell your shares. Below, I will lay out some foundational information you need to develop a framework for handling your corporate stock shares.
My goal is to provide you with a decision-making tool to help you move forward, rather than allow questions and uncertainty to block the achievement of your financial goals.
What is equity-based compensation?
There are a few different forms of equity-based incentive compensation, each with specific rules you need to understand. Today, we are going to look at three of the most common types:
Restricted Stock Units,
Employee Stock Purchase Plans, and
Employee Stock Options (non-qualified and incentive stock options).
Restricted Stock Units (RSUs) aren’t shares themselves but represent shares of stock that you will be given once certain conditions are met. Those conditions are typically met over time based on a given vesting schedule. For example, if you were granted 400 shares on 3/15/20, you may receive 25% of the total grant (100 shares) each year on that date for the next four years. Usually, you must continue to work for the company on each successive date to receive those shares. You will incur income taxes (based on ordinary income tax rates) based on the fair market value of the shares as they are actually given to you, i.e. as they vest.
Employee Stock Purchase Plans (ESPPs) allow you to purchase shares of your employer’s stock at a discounted price (up to 15%) through payroll deduction. Generally, you will incur a tax obligation only after you sell the shares you acquire through an ESPP. It is important to keep in mind that the value of the discount you received will be taxed as ordinary income and that you must hold the shares for both two years beyond the offer date and one year beyond the purchase date in order to qualify for the more preferential long-term capital gains treatment.
Employee Stock Options are non-traded call options that allow you to purchase shares of your employer at a predetermined price, called the strike price. Typically, the strike price will be above the current market price to incentivize performance. You are not taxed on the receipt of the option itself but will owe income tax on the “bargain element,” or the difference between the market price and the strike price at the time of exercise. For non-qualified stock options (NSOs), such income is taxed as ordinary income, whereas for incentive stock options (ISOs), such income is only considered for alternative minimum tax (AMT) purposes. Beyond that, as you sell the shares that you previously exercised, any additional gains or losses will be taxed according to the general capital gains rules.
Take stock (pun intended!)
There are a lot of intricate details that affect the value of, and tax liability on, your equity compensation. It's helpful to use a spreadsheet to track all the different types of corporate stock that you have and that will vest in the future. Accurately tracking this data will enable you to create a solid plan to both know when to buy (exercise your options) and when you have accumulated a sufficient amount such that it’s time to sell.
Here's the pertinent information to collect for each type of option:
For RSUs, the date of grant, date the shares vest, the number of shares, taxable gain on the vest (to establish cost basis, which you can get from your confirmation statement or payslip), and any shares you sold to cover taxes (so you know how many shares you still own).
For ESPPs, make sure to record the offer date, purchase date, the number of shares, and purchase cost so you can establish your cost basis. This is vital for tracking your tax liability. You can get the cost-basis from your actual trade confirmation, which I recommend keeping as well.
Options are a little tricker. You first need to know if you have incentive stock options (ISOs), or non-qualified stock options (NSOs) because they are taxed differently. Regardless of which
type of option you have, you need to record the date of the grant, date your options vest, option expiration, the number of shares, strike price, the purchase cost of any shares you acquire (again, get this from your trade confirmation), and any taxable compensation reflecting the bargain element (reported on your payslip) as you exercise them.
Additional notes:
If you received a grant of Restricted Stock (which is different than Restricted Stock Units, or RSUs) and made an 83b election, you need to confirm that it was timely filed with the IRS and that any taxable gain was reported (or will be if the election was made in the current tax year) on your tax return. You also need to track the date and cost of any share purchases.
For all forms of equity compensation, if you have subsequently sold shares, be sure to record the date of sale, the number of shares sold, and selling price - this will both help you accurately keep track of the shares you still hold, as well as provide some important guidance to your tax preparer.
What are your options?
There are several questions to consider when developing a plan, such as:
How much of your employer's stock do you feel comfortable holding, both in terms of a total amount and as a percentage of your portfolio? When answering this question, consider that your income also comes from this employer. If your employer’s stock price takes a hit, then both your income and the share of your total portfolio value you have tied up in equity compensation are at risk.
How much risk can you afford to take? If you are close to retirement or have a modest portfolio, you might want to place a stronger emphasis on diversification since a material drop in the share price could wipe out a significant portion of your savings if it’s concentrated in your employer’s stock.
What are your cash flow needs? Do you have a sufficient emergency fund, revolving credit card debt, or student loans that should be paid off, or are you saving to purchase a home or send your child to college? In which case it might make more sense to exercise and sell shares earlier so that you can make progress toward these important financial goals.
All these questions present concerns about accumulating too much of your employer’s stock through an equity compensation plan.
To address these issues, it’s best to have an organized and thought-out plan for systematically reducing your position in your employer’s stock. You can do this by establishing objective criteria that pre-determine when you should sell.
A simple way to handle this is to establish a timeline to sell a certain number of shares each quarter, or you could sell at certain price intervals. For example, you could sell a certain percentage of your shares (such as 10%) when the price reaches predetermined levels (such as $238). You’ll need to think about a reasonable series of prices relevant to your company stock’s historical trajectory.
I recommend that you either establish a timeline or combine the two methods. For example, decide to sell 10% of your shares on the 15th day of the first month of each quarter, but sell 15% if the price is at a certain level or higher.
No matter how you choose to devise a strategy, it is very important to establish the criteria beforehand so that you are more likely to follow through and implement your plan once the time comes. Otherwise, you’ll second-guess yourself and your emotions are likely to get involved.
What comes next?
As we have outlined, there are many critical elements to consider when developing a plan for when to exercise and sell your employer’s stock. Depending on how much equity compensation you have and expect to receive in the future, how you handle it could have a significant impact on your overall financial well-being as well as your tax bill.
If you have questions or would like to discuss developing a plan for your own equity compensation, let's talk.
