Today I want to talk about one of the most important components of equity compensation. Actually, it is one of the most important parts of any successful investing strategy – taxes.
If you know me, you know I have a mantra when it comes to investments and taxes – “It’s not what you make. It’s what you keep.” This is key because if you end up losing a good portion of your investment returns to taxes every year, you lose the effectiveness of compounding over time. While we do not have complete control over taxes, there are things we can do.
Now, to get back to taxes and equity compensation, I am going to start with some of the basics here. We’re going to stay high level when it comes to the main components of equity compensation I deal with: Non-Qualified Stock Options, usually called NSOs. Restricted Stock Units, referred to as RSUs. Also, Restricted Stock, which are often called by this name of Restricted Stock Awards or Grants. And finally, Employee Stock Purchase Plans, known as ESPPs. Again, these are the big types of Equity Compensation in my world so that is where we are going spend our time today.
Let’s begin with NSOs. Oh, I may switch back and forth between calling these NSOs and Non-Qualified Stock Options. They are often referred to as stock options as well. Just know I am referring to the same thing. Another type of stock option is the Incentive Stock Option, or ISO. I am not going to cover those whatsoever as I do not deal with them.
Okay, back on topic about taxes of NSOs. If you have NSOs, your employer granted you a set number of shares that have a designated timeframe associated with them. This timeframe is when you can buy the shares, better known as exercising your options. Now, NSOs do not have the special tax treatment that ISOs have. The nice thing is this makes taxation of NSOs pretty straight forward.
One thing I want to clear up right now is there is no 83b election when it comes to standard NSOs. 83b allows tax savings when you receive stock that is not yet vested. The reason it does not apply to normal NSOs is because you are NOT receiving stock. You are receiving an OPTION to buy stock. While this may seem like a small difference, it isn’t when it comes to taxes.
As I mentioned previously, most stock options are not fully vested when they are granted. This means they are not fully exercisable. The rules of when and how you can exercise your options are contained in the stock option plan document your employer provides. Once your options are exercisable there still are no taxes to be paid. Basically, the IRS doesn’t care until you actually exercise them.
Alright, let’s get to the meat of taxes for nonqualified stock options. There are two terms to get comfortable with. The first is compensation income and the next is capital gains. Let’s talk about the former first.
When you go ahead and exercise your options, you have to report income equal to the bargain element of the option at the time you exercise. In layman’s terms, this means your compensation income is equal to the difference between the value of the stock and the amount you pay to exercise the option. A simple example is if you pay $11,000 to exercise a nonqualified stock option for stock that is actually worth $15,000, you will report income of $4,000.
Something to remember is the income amount is fixed on the date your exercise the option, even if you continue to hold the shares by not selling them. If the stock price drops later after you have exercised the option and before you sell them, your reportable income amount will not drop even though the value of the shares have dropped.
Let’s talk quickly about capital gains with NSOs. The general capital gain rule is that if you’ve held an investment for at least one year and one day you can pay taxes at a capital gains rate, which could be lower than your compensation income rate. Capital gains can come into play with NSOs if you hold onto the shares after you have exercised them and them sell them for a higher price. Think of this example as two steps. As I mentioned before, when you exercised the options at $11,000 when they were trading at $15,000 you had compensation income of $4,000. Let’s say you held onto those exercised shares for some more time and they went up in price for a total of value of $20,000. You now sell them for an additional gain of $5,000, which can be treated as capital gains. So, the first tax bill when you exercised is for compensation income and the next for when you actually sell the shares down the road may be for capital gains.
We can get much deeper into taxes with NSOs, but I will save that for another time. How about we jump over to Restricted Stock, both Units and regular restricted stock.
A quick refresher here. Restricted Stock Units (RSUs) give you the right to receive stock after you’ve satisfied any conditions set forth by your employer. This might be hitting a sales goal or revenue objective, but most times it is just staying there for a certain amount of time. When you fulfill the conditions you get the RSUs. If not, then you get nothing. Kind of like the Soup Nazi from Seinfeld. Simply, you have to earn the share.
Now Restricted Stock, also known as Restricted Stock Awards or Grants, are basically the same as RSUs, except you get the stock right away. However, you will forfeit the shares if you don’t meet the associated conditions laid out by the employers. I guess this is similar to the Soup Nazi, like if you ask for bread. In the case of Restricted Stock, the shares are held in escrow, so no yanking them out of your hand. Although they are sitting in escrow, you are still considered the owner so you get dividends and can vote as a shareholder. Here is one more big difference between RSUs and Restricted Stock. The 83b election can be used with Restricted Stock, but not RSUs. I have no Seinfeld reference for this.
Let’s get into the tax specifics for RSUs. When your RSU is vested, meaning you have full control over it because you met the conditions, you have to report compensation income for that year. The income is the fair market value of the stock when you received it and reduced by any amount you paid for it. Again, this happens when the RSUs vest and not when they are granted. That’s it. At least for part 1.
Part two with RSUs comes into play when you actually sell and dispose of the share. Fortunately, this is rather simple as if you have held those RSUs after vesting for at least a year and a day you are now looking at long-term capital gains. Shorter than this period of time results in a short-term capital gain.
Restricted Stock is a little more complex because of the 83b election opportunity. When you receive Restricted Stock it is not vested. You then have a choice between two different tax treatments. Note you need to make a tax choice within 30 days of receipt.
How about we assume you do nothing when you get the Restricted Stock that is not yet vested. There is nothing to do except to keep records of the stock you acquired, when, and the amount you paid, if any. This is for future filings.
Recall that with Restricted Stock you are eligible for dividends. Even though you aren’t yet vested you are still getting the dividends and they are being treated as compensation income. Now, once your Restricted Stock has vested you get to report compensation income equal to the difference between fair market value and any amount you paid for the Stock. Any increase in value from when the Restricted Stock was awarded and when it vests is treated as compensation income.
There are more tax rules with Restricted Stock and we’ll save those for another day. I want to jump to the 83b election.
Okay, let’s assume you have received Restricted Stock and you decide to go the 83b election route. First step is you need to actually make the election within 30 days of receiving the stock. The stock goes into escrow and the clock starts ticking on the actual election notice you have to send to the IRS. Do NOT wait until you file your taxes as odds are it will be too late! 83b is actually rather straightforward. This election treats the Restricted Stock as though it is fully vested when you receive it. You report compensation income based on the value of the stock at the time you receive it. Dividends will then qualify for lower taxes too. Pretty cool, assuming your Restricted Stock goes up in value.
Taxes for the sale of Restricted Stock is similar to that of Restricted Stock Units. Any change in value after the shares are vested and you have recognized compensation income is then treated as capital gains.
We have finally hit the last tax topic to cover today. Taxes on Employee Stock Purchase Plans (ESPPs). This is my favorite type of equity compensation as almost every full-time employee can participate in this plan throughout payroll deduction. ESPPs can take one of two forms – Qualified or Nonqualified. Qualified plans are more common, but nonqualified are simpler.
There is no special tax treatment for nonqualified ESPPs. If you pay full price for the shares in this type of plan they are treated identically to if you bought them in the stock market. Nothing to report and gains and losses are treated like capital gains or losses. If you paid less to acquire the shares than their actual value at the time of purchase this difference is treated as compensation income. This compensation income will be reported as wages on your W-2 and there will be withholdings.
For qualified ESPPs there is nothing to report when acquiring the stock, even if you bought it at a discount. Additionally, there is no income on your tax return and no Alternative Minimum Tax (AMT) either. Your employer will provide you a Form 3922 for the year of the ESPP stock purchase, but you don’t do anything with the form until you dispose of the shares. So, keep it in a safe place because there are some odd rules that then come into play.
I am not going to go into great detail on these rules. Why? Well, because the ESPP is so popular and the rules can get confusing so I want to dedicate an entire article just to this. However, the key element is the holding period. The tax treatment of a sale depends on how long you hold the shares. The holding period requirement is met on the later of the following two dates:
- The date two years after the company granted the option.
- The date one year after you received the stock.
Okay, that is enough for today’s post. I said I was going to stay higher level with the taxes on the three most common types of equity compensation plans I see. I ended up going a bit deeper, but there is still a ton more we will cover down the road.