Equity Compensation Advisor

Knowing the different types of equity awards that corporations issue and what the executive owns is important.
• Restricted Stock Grants
These awards of company stock are referred to as restricted because the executive is restricted from selling the shares for a period of time. Usually this is through a vesting schedule so that employee will forfeit some or all of the shares if they terminate before the shares are vested.
• Restricted Stock Units (RSU’s)
The main difference between restricted stock units and restricted stock grants is the date when the company transfers the shares. Restricted Stock Grants are transferred at the time of the grant. Restricted Stock Units transfer the shares at the time of the vesting date. Therefore, the holder of the RSU’s will not benefit from any dividends that have been paid prior to the date of transfer.
• Stock Appreciation Rights (SAR’s)
SAR’s allow the executive to receive cash in the amount equal to the increase in value based on the original stock price and the number of shares that were issued.
SAR’s are similar to options because the holder determines when to exercise the rights subject to the vesting schedule. Exercising the SAR provides the holder with immediate cash unless the company granted the SAR’s to pay off in stock.
• Non-qualified Stock Option (NQO)
NQO’s permit the option holder to purchase a specific number of shares of company stock at a specific price the day the company granted the options. The option holder must pay the exercise price (grant price) at the time of exercise. The difference between the exercise price and current price is the gain (bargain element). NQO’s are options that do not qualify for special tax treatment.
• Incentive Stock Options (ISO’s)
The main difference between NQO’s and ISO’s is ISO’s do qualify for special tax treatment, allowing the option holder to convert some or all of the income into capital gains. The rules and strategies to take advantage of the special tax treatment can be complicated. The main reason a company would issue ISO’s is to provide a tax benefit to the option holder.
I will discuss the tax consequences of each of these equity awards in the following 5 part series.

Securities and advisory services offered through LPL Financial, a Registered Investment Advisory, Member FINRA/SIPC

One of the more common questions I am asked from clients is “What are the tax consequences of owning stock options?” This remains a hot topic for discussion at any time of the year. As tax season quickly approaches, having a thorough understanding of the tax implications involved can be crucial to minimizing taxation exposure . A more in-depth, comprehensive look at the tax consequences will be explored in a later blog to come. For the purposes of this discussion, I intend to illustrate a general understanding including a hypothetical example.

Taxability-wise, stock option plans raise a number of questions. For example, is the exercise of the option taxable? If not, when is the transaction subject to tax? These questions are very broad and there a many determinants of the taxability of stock options. For tax purposes, there are basically two types of stock options. Lets break this down in simple form.

Differentiation:

The first step is determining whether the options are Type 1: Non-qualified or Type 2: ISO’s (Incentive stock options).

ISO’s receive special tax treatment and can be very complicated. (In a later blog we will delve deeper into the special tax treatments and elaborate on taxability issues and how they relate.)

The tax implications of non-qualified stock options are fairly straight forward.

Implications:

Simply stated, the employee does not report income at the time they receive the options or when they vest. Upon exercising the option, they would report compensation (ordinary) income equal to the difference the amount paid to buy the option (grant price) and the current value of the stock. This income is reported whether the stock is sold immediately in a cashless exercise or if the stock is held. If the stock is held, the current market price is the new basis for the shares.

Example: (This is a hypothetical example and is not representative of any specific investment. Your results may vary)

Steve has 5,000 shares of non-qualified stock options with a grant price of $15/share. The current price of the stock is $25/share. If he paid $75,000 (5,000 x $15) to exercise the shares that are worth $125,000 (5,000 x$25) he would report compensation income of $50,000 ($125,000-$75,000).

Dan’s Moral: Understanding your stock option tax consequences can be daunting and ultimately, careful consideration of how and when to exercise those options to minimize your tax liability is essential.

Daniel Langworthy is the founder and president of Executive Capital, LLC, an investment firm working exclusively with Executives of public companies.

Daniel Langworthy does not provide tax advice. Please consult a qualified tax advisor.

Securities and advisory services offered through LPL Financial, a Registered Investment Advisory, Member FINRA/SIPC