“You’re working for a start-up?”
“That’s awesome! What does the company do? Do you have equity in the company?”
These questions are increasingly commonplace and a focal point for Gen Z and millennials across the country as they mature in their careers. But what does “having equity” really mean? And how does this impact their financial picture?
When accepting a job offer, it is essential to understand how to take advantage of these benefits while also reducing risk in the process.
Why Do Companies Offer Equity Compensation to Employees?
Equity compensation is a way of giving employees partial ownership of the company and its profits. Having “skin in the game” may compel employees to excel in their roles and help contribute to the company’s overall growth – potentially impacting the stock price positively.
Companies may offer an equity stake as an incentive in the hiring process when they cannot afford large cash salaries or as a strategy to lock in talent through multi-year vesting schedules. Understanding the details will help when signing an offer letter.
What are Restricted Stock Units, Often Referred to as “RSUs”?
Restricted Stock Units are a form of equity compensation typically offered after a company goes public or reaches a more stable valuation. RSUs vest, or become owned assets of the employee, over time, without having to buy them. As soon as they vest, they are no longer restricted and are treated the same as if you had bought your company’s shares on the open market.
How are RSUs Taxed?
RSUs are taxed as ordinary income on their vest date, based on the value of the shares on that date, regardless of whether you sell or hold the shares. As a result, employees have no control over the timing of taxes. To avoid a large tax bill when filing your return, it is important to select an appropriate tax withholding rate on the vested shares, factoring in all your income. Preparing a projected tax return can help illustrate the tax consequences of vesting RSUs and allow you to plan accordingly. Even if you do a good job estimating your tax liability, you should be prepared that your estimated withholding amount may not cover your entire tax bill.
When Should You Sell Your RSUs?
Everyone’s goals and circumstances differ. Your specific needs will dictate the best time to sell. However, in most cases, it’s ideal to sell your RSU shares as they vest if it’s within an open trading window and outside any lock-up period. If shares are sold when they vest, there will be no capital gains tax, and the proceeds can then be used to rebalance into a well-diversified investment portfolio, pay down debt, or put toward a major expense like a car or a home.
What are Employee Stock Options?
Stock Options give an employee the right, within a defined timeframe, to buy a set number of company shares at a preset price, or strike price. Vesting schedules dictate when the employee can exercise their options. If the stock price goes up by the time the option vests, it is considered “in the money;” if the stock price never goes above the strike price, these options can expire worthless.
The two types of stock options are the more commonly used Nonqualified Stock Options (NQSOs), which, as the name implies, do not receive preferential tax treatment, and Incentive Stock Options (ISOs), which are tax-qualified and have numerous requirements that must be met under the tax code to qualify for the tax-favored status.
Stock options can be paid for by using cash upfront to exercise, or they can be exercised in a cashless transaction if the company is public. Typically, a cashless exercise is coupled simultaneously with an immediate sale of the stock. In this case, the employee gets the difference between the market value of the stock minus the exercise price and other associated costs and taxes in cash.
How are Employee Stock Options Taxed?
NQSOs are not taxed until the date of exercise. On the exercise date, the “bargain element” – the market value of the stock minus the option’s exercise price – generates income that is taxed at ordinary income rates and is subject to payroll taxes. The taxable basis of the stock is equal to the option’s exercise price plus the ordinary income recognized on the exercise date. This date becomes the start of the stock’s holding period.
For ISOs, while there is no regular taxable event on the exercise date, an alternative minimum tax (AMT) event may occur, and the bargain element of the ISO must be reported as of the exercise date as an AMT adjustment item.
When Should You Exercise and Sell Non-qualified Employee Stock Options?
The ability to postpone paying income taxes on stock options until the exercise date adds an additional component when answering this question. There are a few financial planning topics to consider when deciding when to exercise.
Understanding the time frame you have to exercise options after they vest is of utmost importance, as some employees simply forget about the deadline or wait too long to exercise and let the option expire worthless. If you believe in your company’s future, you may want to hold on to your options. If your company’s share price rises, your options’ worth will continue to grow while putting off any tax consequences. But once you are within two years of the expiration date of that option, you need to begin to consider exercising, even if the stock price isn’t where you’d like to be, to avoid running out of time.
It only makes sense to exercise your options if they have a value, or the exercise price of your stock option is lower than the stock’s current market price. Once your options are “in the money,” there are other elements to consider when deciding when to exercise. If your income for the year already puts you in a high tax bracket, or additional income from exercising stock options could push you into a higher income tax bracket, you may want to delay exercising or spread exercising over a few years.
There is a lot to consider regarding equity compensation and how best to handle concentrated stock positions. To find out more about these strategies, stay tuned for our next blog on this topic or speak to your financial advisor for additional investment management advice.