Why Is Planning Around Your Employee Stock Options So Important?
Written by: Vincenzo Testa, CPA
Equity compensation is one of many benefits that employers are offering more frequently to hold onto their valuable employees. Sure, in general, employees know when they are granted their stock options, when they vest or their strike price. But are those same employees able to calculate the potential significant tax liability that arises from exercising their incentivized stock options or from selling stock that they purchased through their company’s employee stock purchase plan? If you receive stock options or other equity as part of a compensation package from your employer, you have the opportunity for effective and efficient Tax Planning and Risk Management, as a result. If these subject matters are not addressed by a professional, the recipient of the equity compensation could find themselves financially exposed.
Tax Planning
There are multiple strategies that recipients of equity compensation can take to minimize their tax liability. If you receive Incentivized Stock Options, or ‘ISOs, as compensation, you could be subject to Alternative Minimum Tax[i] when you exercise those options. Even if you do not sell the options immediately, you could be subject to a tax bill because you purchased stock as opposed to selling your stock. There are ways to reduce the amount of AMT liability at exercise. This is very crucial because when a taxpayer exercises ISO’s, they may want to only purchase the options rather than purchase and immediately sell. A taxpayer may wish to only purchase the options so they can hold the options for one year after exercise and two years after the date of grant and capitalize on preferential Long-Term Capital Gains Tax Rates. If a taxpayer triggers AMT from solely purchasing and holding, how will they satisfy the tax bill if they did not receive any proceeds from a sale of the options?
One strategy is to find the AMT Crossover Point. This strategy determines how many ISO’s a taxpayer can exercise in one year before they trigger the AMT on their tax return. This takes incredibly careful Tax Planning, and any recipient of ISO’s should work with a professional on this matter. This would eliminate any AMT that the taxpayer would be subject to year after year.
Another strategy to avoid Alternative Minimum Tax when receiving ISO’s is filing a Section 83(b) election[ii]. This election allows a recipient of ISOs to pay tax based on the Fair Market Value of the stock options when they are granted rather than after the Fair Market Value grows at a future date. The Strike Price and Fair Market Value of the options would be almost always the same at the time the election is filed, meaning there will be a spread of $0 to add back to calculate a taxpayers AMT. In the case of Restricted Stock Units, or RSUs, an 83(b) election would allow a recipient to be taxed at the grant price of the RSU’s rather than the vested price. This would result in significant tax savings in most cases.
Risk Management
Diversify, diversify, diversify. We have all heard that saying time and time again. My colleague Nicole Gobel, CPA wrote a blog just last week called "Don't Put All Your Eggs in One Basket". The blog addresses the risks and downfalls that come with not diversifying your assets. If most of your household income is generated from one company and you also have half of your expected retirement assets sitting in equity in the same company, you could be financially exposed in a severe way. If that company fails, so does your financial and retirement plan.
In a perfect world, you want to exit your equity compensation positions as quickly as possible, but also in the most tax-efficient manner. The timeliness of exiting the positions may have to suffer to take advantage of preferential Long Term Capital Gains Rates. When you exit the equity compensation positions, you will want to take the proceeds and invest in a diversified portfolio. By diversified portfolio, I mean multiple exchanged-traded funds or mutual funds that contain various individual holdings in various industries. This allows an investor to reduce Unsystematic Risk, or risks specific to one industry or company. Systematic Risk, or market risk, is impossible to eliminate. Although it can be dealt with, Systematic Risk always exists when invested in the equity, fixed income, or alternative markets.
When it comes to equity compensation, risk management is crucial. We have seen employees of companies like Enron, WorldCom, and Bear Stearns lose control of their financial lives from being overexposed in those companies.
How Do You Begin?
If you receive equity compensation from your employer, contact a financial professional to start addressing Tax Planning and Risk Mitigation issues. If you are already a client of Bouchey Financial Group and need assistance with these matters, contact one of our advisors to get started. If you are not a client of Bouchey Financial Group, contact us for a consultation to see if our firm can assist you with your financial situation.
Resources
ISO’s & AMT - https://secfi.com/learn/avoiding-amt-taxes-iso-stock-options
83(b) Election - https://www.cooleygo.com/what-is-a-section-83b-election/
Don't Put All Your Eggs in One Basket
Bouchey Financial Group has local offices in Saratoga Springs and Downtown Historic Troy, NY.
[i]Alternative Minimum Tax places a floor on the percentage of taxes that a filer must pay to the government, no matter how many deductions or credits the filer may claim.
[ii] Section 83(b) Election is a provision under the Internal Revenue Code (IRC) that gives an employee, or startup founder, the option to pay taxes on the total fair market value of restricted stock at the time of granting