Understanding Your Equity Compensation Grants in the New Year

Jan 16, 2020

Guest Blog by Beata Dragovics, CFP®, CEP®, Financial Advisor & Principal, Freedom Trail Financial

The beginning of a new year often comes with new equity compensation grants, such as stock options, restricted stock, restricted stock units, or performance shares. To help you maximize the value of these benefits, let’s review the basics for the most common equity grants, how they’re taxed, and the potential benefits of each.

Stock Options Basics

A stock option grant gives you the right to buy company stock at a certain price (the grant price) beginning on a certain date in the future. After your stock options vest, you have the option of exercising the options at the grant price. For that to happen and be worthwhile at the same time, the market price of the stock must be higher than the grant price at the time of exercise. When this happens, your options are considered to be “in the money.” To exercise your options, you buy the stock at the grant price and pay taxes on the spread—the difference between the current stock price and the grant price.

Non-Qualified Options vs. Incentive Stock Options

With non-qualified options, there is no holding period required. If your options are in the money, they can be exercised as soon as they vest. The spread (as described above) will be taxed as ordinary income. If you decide to exercise and sell, there are no further tax implications. However, if you decide to exercise and hold the stock, long term capital gain taxes will also apply if you sell after a one-year holding period.

Incentive stock options (ISOs) offer preferential tax treatment—no ordinary income tax is due when you exercise. To qualify for this preferential tax treatment, you must hold the stock for two years from the grant date and one year from the exercise date. If you sell your shares early, the sale will be treated as a disqualifying disposition, the options become non-qualified, and taxes will be due.

If you hold the stock for one more year from exercise and two years from grant, any capital gains above the grant price are subject to long-term capital gains taxes. Note that the Tax Cuts and Jobs Act increased both the income exemption amount as well as the income phase-out at which incentive stock options do not trigger the Alternative Minimum Tax (AMT).

Remember, if your company stock has significant upside potential, your options can have tremendous value. On the other hand, your options can expire worthless if the stock price falls below the grant price.

Restricted Stock Units (RSUs) vs. Restricted Stock

Restricted stock units and restricted stock represent a transfer of company stock from the employer to an employee based on a vesting schedule. When RSUs vest, the value of the grants is taxed as ordinary income; therefore, knowing your vesting schedule allows you to estimate your future income. RSUs are basically a bookkeeping entry until the grants vest, while restricted stock offers immediate ownership at grant. When restricted stock is granted, shares are issued up front at grant, but you do not own them outright until the restrictions lapse at vesting. Restricted stock is taxed as ordinary income at vesting and not at grant–even though you basically own the stock at grant.

To potentially reduce your tax liability on restricted stock, you can make a Section 83(b) election with the IRS within 30 days of grant. (Please note this is only available in case you are granted restricted stock, not RSUs.) In this case, you pay taxes on the value of the stock at grant and not at exercise. The major advantage can be to pay lower taxes when the stock price is lower than at vesting. You can also start the holding period for long-term capital gains qualification earlier. However, if the company stock price is much lower at vesting than at grant, you can’t recover the taxes you paid in advance.

Performance Shares

Over the past decade, performance shares have become a much more popular form of equity compensation, while stock option grants have become less prevalent. This has a lot to do with the volatility of options versus the surer rewards that performance shares can offer.

Performance shares are usually not granted upfront but rather as part of a long-term incentive plan (LTIP). Performance shares are typically tied to meeting a specific future goal, such as a profit target or total shareholder return relative to the stock market.

Grants can be structured as performance stock awards (PSAs) or performance stock units (PSUs). Each unit has a value-added and at vesting it gets paid in stock or cash or as a combination of both. PSAs and PSUs can be more beneficial than regular restricted stock, as they can offer more than 100% target pay if the company exceeds its performance targets.

As you can see, equity compensation grants can be complex and there are many factors to consider. If you need help sorting through your options, please contact me with any questions you may have.

Please be sure to consult a tax advisor before making any decisions around your equity compensation grants.

Securities and advisory services offered through Commonwealth Financial Network®, member FINRA/SIPC, a Registered Investment Adviser. Financial Planning services offered through Freedom Trail Financial, LLC are separate and unrelated to Commonwealth. Freedom Trail Financial, LLC does not provide legal or tax advice. You should consult a legal or tax professional regarding your individual situation. As a Registered Investment Adviser, Freedom Trail Financial offers financial planning services for a fee that are separate and unrelated to our relationship with Commonwealth.

About The Author

Beata Dragovics

Beata Dragovics
Founder, Financial Advisor & Principal, Freedom Trail Financial, LLC

Beata Dragovics is the founder of Freedom Trail Financial, LLC, a boutique wealth management firm in Boston. She provides customized financial planning and investment management services, with a particular focus on clients who work within the life sciences industry.

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