Year End Planning for Equity Compensation: Tax Implications - Part 2 of 6
For this second installment, I’d like to provide a high-level overview of the tax implications when RSUs vest, ISOs and NQSOs are exercised, and resulting shares from each of these methods are sold.
Why? Because understanding the details will allow you to understand the planning opportunities around each of these decisions, which affect your cash flow, tax liabilities, and investment portfolio – in summary, your ability to achieve your long-term goals. Are you convinced?
When you’ve been granted RSUs, at each vesting date, the shares will be reported as compensation to you based on the current fair market value. Assuming the shares are valued at $45/share when they vest, you’ll have taxable compensation of $4,500.
Some shares will be sold to cover the tax liability (Federal, state, social security and Medicare), and the remaining shares will be transferred to your brokerage account.
What choices do you have? Occasionally you can elect to pay the taxes out of pocket, in order to receive all your shares, but I rarely recommend this – one of the biggest challenges when working with clients who have equity awards is reducing the holdings down to what would be considered a properly diversified portfolio – i.e. holding a maximum of 5-10% of your net worth in your employer’s stock. So “selling to cover” the tax liability upon vest is a no-brainer – no need to compound the concentration with having to cover the tax bill out of pocket.
What do you need to look out for? Typically, companies only withhold Federal taxes at the 22% statutory rate – even if you’re in the 37% tax bracket. So you should plan to set this amount of funds aside in order to cover the tax liability, either at the next quarterly due date or with your tax return by April 15 of the following year.
In our example where 10 shares vested at a current fair market value of $45, for total compensation of $4,500 – if you’re in the 37% tax bracket but had only 22% Federal taxes withheld, then you’ll need to set aside the additional 15%, or $675.
At this point, your only decision is whether to sell or hold onto the remaining shares. If the latter, plan to keep them for at least a year to benefit from the preferential long-term capital gains tax rates. Otherwise, some of the considerations would be a need for the cash to meet other goals, and how much concentration in your employer’s stock you already hold.
TLDR: RSUs are essentially free money, so they’re a great way to raise funds to meet your goals.
Incentive Stock Options (ISOs) and Non-Qualified Stock Options (NQSOs)
With ISOs and NQSOs, you don’t receive the shares automatically when they vest, but you have to make a decision to exercise (i.e. purchase) them. This is the key difference between options and RSUs – with options, you need to make a proactive decision and come up with the cash required to purchase the shares. But the good news is that you can buy the shares at a discount to current fair market value (FMV) based on the strike price listed in your grant award.
For both types of options, when you make the decision to exercise them, you need to have the cash to purchase them: 100 shares x 5/share strike price = $500 – even if the fair market value is now $45 per share. But after that point, ISOs and NQSOs have different and more complicated tax and therefore cash flow implications.
If the current fair market value is $45 per share, the difference between that and the strike price – i.e. the amount that it costs you to purchase the shares, is treated as compensation. Like RSUs, typically a certain number of shares are withheld to cover the resulting tax liability, and the net shares are deposited into your brokerage account, assuming you elect to sell to cover.
But unlike RSUs, the taxable compensation in this case is only the “bargain element” – the portion of the value that you didn’t pay for – i.e. ($45 FMV less $5 strike price) x 100 = $4,000. It’s important to note that when you go to sell these shares, the full cost basis is the $5 you paid + the $40 that was treated as taxable compensation.
TIP: If you prepare your own tax returns, make sure to read the footnotes to your consolidated Forms 1099 so that you report the full cost basis, not just the $5 that gets reported to the IRS – it could literally save you thousands of dollars in taxes.
The tax and cash flow issues are even more complicated, but still manageable with careful planning, because the implications will carry over multiple years.
Using the same details as in the prior example, if the current fair market value is $45, the difference between the fair market value and the strike price is again treated as compensation – but only for AMT purposes.
Similar to NQSOs, the taxable compensation is the bargain element that you didn’t pay for – i.e. ($45 FMV less 5 strike price) x 100 = $4,000. No taxes are withheld when you exercise – the compensation is not included in your W-2, but the bargain element will be treated as an adjustment for Alternative Minimum Tax (AMT) purposes, and may create an AMT tax liability where you wouldn’t otherwise have one.
TIP: If you are required to pay AMT (or have ever done so in the past), you should note that the AMT is not a permanent tax, but essentially a timing difference – any AMT that you pay will be carried forward as a future credit against your ordinary income tax liability. So you want to make sure that your tax returns include the carryforward calculation, and that the credit is picked up on future tax returns.
TLDR: ISOs and NQSOs are more complicated so require a bit of planning (especially ISOs). Professional guidance is strongly recommended.
Selling Your Stock Shares
Once your RSUs have vested, and you’ve exercised your ISOs and NQSOs – the next step is to sell them. The holding period is considered to begin the day after the RSUs vest and the ISOs and NQSOs are exercised. This is important because it affects the taxation when you sell the shares: for stocks held long term (more than a year), you receive the benefit of the preferential long-term capital gains tax rates (maximum 20%), whereas if you self them before then, you’ll pay taxes on the resulting gains at your marginal income tax rate (as high as 37%).
One other tax to note is the Net Investment Income Tax (NIIT), which is an additional 3.8% tax on net investment income once your taxable income exceeds $200,000 (if filing single) or $250,000 (if married filing jointly).
As you can see, there are not one but two points of taxation that you need to plan for – at vest for RSUs or at exercise for ISOs and NQSOs, and at the sale of the stock shares – as well as four types of taxes: ordinary income, capital gains, NIIT, and AMT. So you can see that planning for these decisions can affect both your tax liability and cash flow, and ultimately your ability to fund your long-term goals. (Not to mention your sanity.)
Sounds complicated? Don’t hesitate to schedule a free consultation to discuss how we can create a simple plan to help you manage your equity awards with confidence.