Financial Planning for Stock Based Compensation

| January 24, 2019
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Retaining employees can be quite a challenge these days, particularly for high-demand industries. If an employee has a college degree, great work ethic, marketable skills, etc., he/she will be an incredible asset to the current company, but on the flip-side, the employee will also likely be on the radar of recruiters for other companies who are seeking such a person. Even with wonderful coworkers, empathetic managers, and an excellent company culture, it’s difficult to turn down a higher-paying job offer. To help combat turnover and increase company loyalty, some firms will offer stock-based compensation or similar incentives (especially to executives). The main strategy to accomplish this is through a vesting schedule, in which the perks of owning company stock are only fully realized when the employee maintains employment for a certain period of time, say five years, in order to meet the vesting requirement.

 Restricted Stock Units

 A RSU is issued to an employee through a vesting plan and distribution schedule after achieving required performance milestones or upon remaining with their employer for a particular length of time. An important point to keep in mind is that the employee obtains an interest in the company stock, but it doesn’t have a tangible value until vesting is complete. Once vested, the stock is assigned a fair market value and considered ordinary income with a portion withheld to pay income taxes. At that point, the employee receives the remaining shares and can sell when desired. RSU’s don’t pay dividends and don’t allow for an 83(b) Election.

Incentive Stock Option

 Another form stock-based compensation is the ISO, which contains several tax advantages. There is no tax due upon grant and unless the alternative minimum tax is applicable, no tax is due upon exercise either. The stockholder also has the option to be taxed at the long-term capital gains tax rate upon sale if the stock is held for one year from the exercise date and two years from the grant date. Regarding long-term capital gains tax, an ISO’s “bargain element” is simply the difference between the market value and the exercise price. It is important to remember the holding period requirement of ISO’s because if the shares are immediately sold upon exercise, then the ordinary tax rate will apply instead of the more advantageous long-term capital gains rate.

Non-qualified Stock Option

A slightly less beneficial stock option a client may have is one that is non-qualified. There is no taxation upon grant, but the bargain element is taxed at the ordinary tax rate upon exercise. Tax treatment is quite simple when sold; if the holding period is one year or less from exercise then a short-term capital gains tax will apply. If held for over a year then a long-term capital gains tax will apply.

83(b) Election

The Internal Revenue Code provides a potential tax advantage for an individual that has stock-based compensation. The section 83(b) election allows the person the option to pay taxes on the total fair market value of restricted stock at the time of granting (before vesting begins). This means that the tax liability will be prepaid at a low valuation assuming the equity value increases in the following years. The worth of shares during the vesting period will not matter as there won’t be any additional tax and the vested shares are retained. Upon sale of the shares for a profit, an appropriate capital gains tax will be applied. This election is optimal when the stock price has a good probability of increasing over time.

Naturally, an 83(b) election makes less sense when a stock declines continuously. In this case, there would be an over-payment in taxes by pre-paying on the higher equity valuation initially. The stock-owner would have been better off without the election and instead been paying an annual tax on the reduced value of the vested equity for each year. Another word of caution is that if the employee leaves the firm before the vesting period is over, he/she would have paid taxes on shares that ultimately aren’t even received!

While it is incredibly difficult to predict a stock’s performance, a judgement call does need to be made in regard to doing an 83(b) election or not, since the future stock values determine if the employee receives an advantageous tax situation.

Equity based compensation certainly complicates a client’s financial plan since there are numerous tax implications to be considered. 

Please consult with your financial planner and/or tax professional before engaging in any securities transactions.  If you don’t have a financial planner with experience in this area or with tax planning expertise, call us to schedule a visit—the team here at Aspen would be happy to help.

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