By Mike Collopy, CFP®, CIMA®
As an employee at a forward-thinking technology firm, your financial landscape is different from others. While most people accumulate wealth primarily from their salaries, technology executives frequently create their fortunes through company ownership, often in the form of stock options as part of their equity compensation package.
However, the potential for higher growth in your stock options also brings an additional layer of complexity, particularly around the area of tax planning. Questions such as the type of stock options you have, the varying tax treatments that come with each option, and potential challenges to anticipate before implementing your stock options strategy all need to be answered.
To help you gain clarity on these questions, read the following insights from our team to understand more about stock options.
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.
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 incentivizes 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.
Helping You Make Sense of Your Options
Do you have stock options at your company but don’t have a plan in place to best utilize them? No worries! Our experienced team at Veracity Capital is here to help. Reach out to schedule a complimentary introductory call by calling 305.723.9949 or emailing firstname.lastname@example.org.
Mike Collopy is wealth advisor and partner at Veracity Capital. As a fiduciary who puts his clients’ interests first, always, Mike is known for providing a holistic perspective on his clients’ finances. His comprehensive process first looks at the big picture of each client’s family, health, and wealth, then drills down to provide solutions for their financial needs, concerns, and goals. He’s passionate about the science of financial planning and investing and uses that to help his clients build a strong foundation for their financial life. Mike serves career-driven individuals who need professional advice to manage their wealth and maximize their opportunities, such as corporate benefits and complicated compensation packages. He considers his clients to be like family, and strives to support them and their families as they work hard for their financial future.
Mike has a bachelor’s degree in finance from Coastal Carolina University and an MBA from The College of Saint Rose. He is also a CERTIFIED FINANCIAL PLANNER™ practitioner and a Certified Investment Management Analyst®. When he’s not working, you can find Mike spending time with his wife and young son, often exploring the great outdoors by hiking or enjoying the beach. He likes to stay active, playing basketball and training for half marathons. Mike gives back to the community by supporting organizations dedicated to finding treatments for cystic fibrosis. To learn more about Mike, connect with him on LinkedIn.
Advisory services offered through Veracity Capital, LLC, a registered investment advisor. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and, unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial advisor and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.