There are a great many and varied ways employers use equity as part of an employee’s compensation. They include: phantom stock to stock appreciate rights and Employee Stock Purchase Plans (ESPP) just to name a few. However, today we will focus on just three types: Non-Qualified Stock Options (NQSO), Incentive Stock Options (ISO) and Restricted Stock Units.
All three have some common characteristics, they all have a vesting schedule and are taxed by the federal and state government in some form. A vesting schedule is simply how much of the equity you get ownership of at a specified time. Most companies have a four year vesting schedule, meaning you earn 100% ownership of all the shares you were given (granted) at the end of four years. Depending on the company and how the plan is created you may start vesting your shares immediately or after one year. Remember, these types of equity compensation are tools your employer is using to retain your services and talent.
A common vesting schedule may look something like this: you are granted 2,000 shares of ACME High Fidelity, Inc on January 1, 2021. Your shares vest over fours on a quarterly basis after one full year of employment. Your first vesting date is January 1, 2022 and you get 500 shares (25% of 2,000). Each quarter thereafter you vest another 125 shares. Assuming you have stayed the whole time at the end of December 2025 you will have vested 100% of your 2,000 shares.
What complicates the comparison of these types of compensation is how they are taxed. We explore the tax implications below.
Restricted Stock Units (RSU)
RSUs have the most straight forward taxation of the three types of compensation under discussion. Referring to the example above let’s say on March 31, 2022 you vest 125 shares of ACME and the market price is $32.50. Since you are given those shares for free by ACME, the government considers that earned income. Therefore, you must pay ordinary income tax on $4,062.50 (125*$32.50). If your marginal tax rate is 37% you pay $1,503.13 in income tax.
Some employers will automatically execute a same-day sale of shares to cover the income tax. However, if your company does not, you have a couple of ways to tackle the tax man. You can treat the RSU as a cash bonus and exercises a same day sale of all shares when they vest. There is no capital gains tax in this situation since you sold the shares immediately upon vesting. You can then save some amount to cover the income tax and invest the rest. Alternatively, you can hold the shares, then at tax time you sell shares that are over a year old to qualify for long-term capital gain treatment. Use those funds to pay the income tax. The potential pitfall here is that you end up in a cycle of selling shares to pay the tax only to create a larger tax burden in the following year.
After the RSUs vest, you can choose to hold the stock for any period of time. In terms of taxation we are concerned with the length of time the stock is held between the vesting date and the date of the sale. If the stock is sold less than one year from the vesting date then any capital gains are taxed at your ordinary income tax rate. Stock that is held for over one year qualifies for favorable tax treatment. Long term gains (gains earned on stock held for more than a year) are taxed at the 15% federal tax rate (for a married couple in 2022 with income between $83,350 and $517,200.
Non-Qualified Stock Options (NQSO)
As mentioned above your granted NQSO will vest over some period of time. With NQSO when they vest you have the option to exercise or not to exercise. This is a key difference compared to RSUs. Another key difference is you have what is called a strike price. The strike price is the price at which you get to buy the shares of stock in the amount you have vested. Similar to RSUs, when you exercise your NQSO you will incur ordinary income tax. The difference is the tax is computed on the difference between the strike price and the market price the day you exercise, we call that the spread.
Back to our ACME example. Your 2021 grant agreement has awarded you 2,000 shares of ACME High Fidelity Inc. to be vested over four years as noted above, with a strike price of $15.00. On March 31, 2022 you vest 125 shares. The market value on March 31, 2022 is $32.50. You decide to exercise your options. The spread is $32.50-$15.00=$17.50. You will pay ordinary income tax on $2,187.50 ($17.50*125=$2,187.50). Note this is much less than the RSU example. This is because you had to pay $15.00 per share to buy the shares.
Now you own 125 shares at a cost of $32.50 per share. This is called the cost basis. As with RSUs if hold you the stock for less than a year you will pay ordinary income tax on the gain (sales price – cost basis = capital gain). If you hold the stock for more than one year you qualify for the long term capital gain treatment as noted above.
Incentive Stock Options (ISO)
ISO’s are similar to both RSUs and NQSO in that there is a grant, a strike price, and a vesting period. The most significant difference is how they are taxed upon sale (or disposition). There are two types of disposition: qualified and non-qualified.
A qualified disposition is one in which the shares are held for more than one year from the date of exercise and two years from the time of the grant. Both conditions must be met for all profit to count as capital gain rather than earned income. This includes the spread (also known as the bargain element) as well as gain on the sale. If these conditions are not met, this is a non-qualified disposition, and the tax treatment is the same at NQSO.
The tricky bit for ISOs, as it relates to taxes, is the bargain element. The bargain element is the spread between the strike price and the fair market value of the stock on the day you exercise. In a qualifying disposition, unlike the NQSO there is no tax liability created when you exercise your ISO. What IS created is called an AMT Adjustment item.
AMT is a tax calculation that adds back several deductions and allowances that you are able to take on your normal federal income tax return. After your AMT tax is calculated and if it is greater than your normal tax you will pay the higher AMT amount. However, you earn what is called an AMT credit. That AMT credit can be used in future years when your normal income tax is lower than the AMT calculation to reduce that year’s tax bill.
Let us return to our ACME example. You are awarded 2,000 shares of ISOs in ACME in January 2021, vesting over four years, with a strike price of $15.00. On March 31, 2022 you vest 125 shares and decided to exercise those options. The bargain element is $17.50 per share. You will have an AMT adjustment of $2,187.50. But no tax liability is created at the time of exercise. You now own 125 shares of ACME. If you hold the shares for more than one year you have a qualifying disposition, and the gain is taxed as a long-term capital gain at the 15% federal rate as noted above. If you sell after holding for less than a year, then you have a non-qualified disposition, and your gains are taxed as ordinary income.
These types of compensation can be especially useful in building wealth for those people who have these types of options as part of their compensation package. Of course, it comes with risk, especially if you are working for a pre-IPO company that is giving you a bunch of options in lieu of some portion of your paid salary. However, the taxation of these options is different and can trip up even the savviest of people. While we have provided a very high level view of how these options work and are taxed we highly recommend anyone with these options speak with a tax professional and/or a financial planner that specializes in this type of compensation for personal guidance on their best tax and income strategies.
Daniel T. Goodman CLU®, CFP®
Director of Financial Planning, Sierra Pacific Financial Advisors, LLC
Daniel has over 20 years in financial planning between corporate and individual financial planning and execution. He enjoys combining his extensive financial planning knowledge and presentation skills to help clients engage and execute their financial plans. He listens to his client’s goals and ideas and then develops holistic and comprehensive plans to meet their goals from estate tax management, legacy planning, and investment perspectives.