Stock Options and Restricted Stock – What You Need to Know About Taxes
Executive compensation plans, including stock-based compensation, are a great way for companies to attract and retain top talent. Understanding the tax implications, however, can be a daunting task.
Many variables come into play, including plan type, qualified or non-qualified status, holding periods, etc. and for busy professionals, just finding time to focus on this can be hard.
That said, it’s important to understand the basics so you can make informed decisions. Here we provide a summary of the tax implications on the most common types of plans we see, stock options, and restricted stock.
The graph below summarizes the different option types and tax treatment:
For NQSO’s, the tax occurs when you exercise, not when the options are granted. The tax is the same regardless if hold the stock after exercising. Unlike ISOs, there is no required holding period from a tax perspective.
Therefore, it’s important to work with your financial team to ensure withholding and estimated tax payments are sufficient when you exercise.
ISOs and the AMT Trap:
ISOs should always be analyzed carefully before exercise since the spread can trigger the dreaded AMT. Although fewer taxpayers are now affected by AMT due to the recent tax code changes, it can still happen. Depending on how well your options have performed, the amount of AMT could be substantial.
In addition, since the stock must be held for a minimum period to get preferential tax treatment (2 years from the grant date/1 year from the exercise date), there is the added risk of the stock falling in value. It’s possible to owe more in AMT than the stock is ultimately worth!
How can you avoid this? You can do what is called a disqualifying disposition. This means exercising and selling your ISO shares in the same calendar year. That effectively turns them into NQSO’s, you erase AMT, and pay ordinary tax on the spread at the time of disposition.
Therefore, it’s generally best to transact ISO shares early in the year. This provides as much time as possible to see how the stock performs.
The taxation of restricted stock depends on the type of plan. There are two major types, RSUs and RSAs:
Restricted Stock Units (RSUs):
RSUs are a promise to transfer stock once vesting conditions are met. With RSUs, executives have few options to control their tax bill. The RSU value is taxed as ordinary income when they vest.
|Restricted Stock Units (RSUs)||
• Assume you have 1,000 RSUs granted 3/1/17, vesting 100% 3/1/20.
• Stock price on 3/1/20 = $10.
• You realize $10,000 of ordinary income at vesting.
After that, it’s capital gain if you hold the stock. Same example:
° You sell on 3/1/21 for $12/share.
° You realize a $2,000 capital gain upon sale
» =$12/share minus $10/share basis (price on vesting date) X 1,000 shares
Restricted Stock Awards (RSAs):
These represent an actual stock transfer, subject to certain conditions and restrictions.
|Restricted Stock Awards (RSAs)||
The big difference with RSAs is the 83(b) election. This allows you to pay tax early, at the grant date. This may make sense if you think the value will be much higher at vesting. Therefore, you pay tax on a much lower value today.
The risks of 83(b) include paying tax on income you essentially haven’t received yet. Other risks include termination of employment before vesting and the risk of paying too much tax if the stock falls. The pros and cons must be carefully analyzed if you are considering this strategy.
Some companies also pay dividends on unvested RSAs, which can be subject to ordinary tax upon receipt.
As you can see, there are many complexities. An experienced team of advisors can help you navigate the nuances and make informed decisions.
Next time we will expand on other types of plans, including phantom stock, stock appreciation rights, and deferred compensation. Stay tuned and stay well.
Gary K. Pattengale, CPA, CFP® is a Wealth Manager at BDF and is a member of the Firm’s Investment Committee. With 20-plus years of professional experience, Gary began his career as a public accountant, training that he uses to help his clients minimize their tax burden. He draws on his extensive experience to provide his clients with strategic insight into the planning and investment strategies most suitable to their circumstances. Gary earned a BS in Accounting from Northern Illinois University as well as the Certified Financial Planner™ and Certified Public Accountant designations. He is recognized as a FIVE STAR Wealth Manager by Chicago magazine and is a member of the American Institute of CPAs and Financial Planning Association.