As a business owner, practice owner, or C-suite executive, your finances and income are complex. And while most people build their wealth from their salary, you might be accruing wealth from ownership in the company you work for with an equity compensation package made up of stock options.
To best understand the stock options you might be signing up for, including the tax ramifications, vesting process, and provisions, check out the following five topics.
1. Non-Qualified Stock Option (NSO)
An NSO is the most common type of stock option where the company grants the employee, and when the employee chooses to exercise them, they will owe ordinary income tax on the difference between the price they exercise and the price they were granted (this difference is commonly called “The Spread”). Since The Spread is treated as W-2 income, the exercise is subject to ordinary income taxes and FICA tax.
These options offer employees an additional type of compensation while allowing flexibility in terms of when to exercise and pay the tax on exercising them. After exercising them, the employee can choose to sell the shares immediately or hold on to them in hopes of further price appreciation.
2. Incentive Stock Options (ISO)
An ISO is a more complex type of stock option than an NSO and allows for special tax treatment as long as certain IRS requirements are met. Unlike the NSO, with an ISO you do not need to pay ordinary income tax at the time of exercising. However, there is a $100,000 limit on the aggregate grant value of ISOs that may first become exercisable (i.e. vest) in any calendar year.
Instead, if you exercise your shares and hold on to them for at least one year from the time of exercise, and two years from the time they were granted to you, then you would qualify for long-term capital gains tax rates, which are typically much lower than ordinary income tax rates. One potential caveat, however, is that you may be subject to the Alternative Minimum Tax when you exercise these options. As the tax consequences are complicated, it is highly recommended you reach out to qualified wealth managers and tax experts to implement the best plan.
3. Vesting
While you may see stock options as part of your overall compensation, that doesn’t necessarily mean that you own them when you join the company. Typically there is a vesting schedule that outlines when the stock options are granted to you, at which point you will be able to exercise and sell them.
While every company will have a different vesting schedule, one common example is a four-year vesting period. This means that an employee will receive 25% of their options every year, which incentives them to stay for four years to receive the full amount.
4. Bargain Element
The bargain element is simply the difference between the price you exercised your shares for and the price at which they were granted to you. The bargain element is essential to calculate as it will be used to determine whether, and how much, you will owe on your alternative minimum tax (AMT). Put simply, the higher the amount of your bargain element, the more likely you will be to owe AMT.
One potential strategy to consider is to exercise up to the point where you will owe AMT, but ensure you do not go above that. Alternatively, you may decide the extra taxes due are worth exercising your shares. As previously stated, careful planning and diligence are necessary to ensure your options strategy aligns with your goals.
5. Clawback Provisions
Most stock option agreements include a special provision that allows the companies to redeem options from employees even if they were already vested. This is known as a clawback provision, and the purpose of this provision is to provide some kind of remedy for the company if an executive has engaged in questionable legal or ethical actions.
However, that is not always the case, and companies like Skype have previously used the clawback provision for many employees even when there was no unethical behavior. While analyzing your company stock options, review any clawback provisions in the options agreement so you know when and how they can be used.
Making Sense of Your Stock Options
If you have stock options at your company and need to create a blueprint, let’s have a conversation. To get in touch today, give us a call at (703) 537-8351 or email thomas@tm-wealth.com.
About Thomas
Thomas R. Seneca is Managing Partner at T.M. Wealth Management, a wealth management firm that focuses on independent, boutique, and fiduciary services for clients. After gaining extensive finance and investment experience working as an investment banker on Wall Street and in Silicon Valley, Thomas had a desire to work more closely with clients and positively impact their lives by helping them make better financial decisions. He started his own practice and now works with successful professionals to help them simplify their financial needs and optimize their wealth to pursue their goals. Thomas knows the positive impact that good financial decisions can have on families and individuals, and he strives to help give clients financial confidence so they can spend their time on what matters most to them.
Thomas holds a bachelor’s degree in economics from Brigham Young University and an MBA from Columbia Business School. Thomas is an avid golfer, fluent in Spanish, and serves as an adjunct finance professor at Virginia International University in the Washington, D.C., area. Outside of work, he enjoys traveling, spending time with family, and attending church. To learn more about Thomas, connect with him on LinkedIn.