Many of our clients at Solidarity Wealth work in high-growth industries (such as technology), and therefore receive stock options as part of their compensation package. While these are certainly a wonderful employee benefit, they come with many complex rules and tax implications. In our experience, too many of these professionals make avoidable mistakes that cost them significant tax dollars or force them to let their valuable options expire before exercise.
Here are some missteps we commonly see—and how you can avoid them.
Not Understanding What You Have and the Terms
There are several types of stock grants and stock options, each having its own set of rules and tax treatment. The most common type of stock grant is the restricted stock unit (RSU). RSUs differ from stock options in that these are grants of actual company stock, not an option to buy stock. In addition, the value of RSUs is determined on the vesting date and are taxed at ordinary income rates in the year vested.
Stock options are rights to purchase company stock at a specified price (called the “strike price”) after a certain period of time (vesting) between the “grant” or award date and the “exercise” date. I discuss the differences between incentive stock options (ISOs) and non-qualified stock options (NSOs) here. Combine this with the intricacies around Qualified Small Business Stock (QSBS) that I discuss here and the acronyms can be hard to keep straight.
Each has different vesting periods and tax treatment, so it’s critical to have a clear understanding of the rules regarding these benefits. For example, many employees might overlook or forget that options have expiration deadlines. There are also specific deadlines to exercise vested options after separation from the company (90 days is the standard).
In high-growth technology, company acquisitions are common; do you know what rules apply to your stock options if your company is acquired? ISOs may also have “disposition periods” that must be met to qualify for special tax treatment.
Overconcentration in Your Company’s Stock
Another common mistake is having too much of your retirement savings account or your net worth in your own company’s stock. The financial landscape is littered with instances where employees with a high percentage of their retirement account in company stock suffered significant losses when their company went bankrupt or the stock plummeted.
Enron and Lehman Bros are often-cited examples, but a more recent example was the venerable General Electric (GE), whose stock price fell from nearly $40/share to $8 in 2008 and then again from $30 to $7 in 2018 after it was dropped from the Dow Jones index (DOW).
Now this is a bit of a Catch-22 as the success stories of long-time early employees of NVIDIA, Apple, Google, etc. have led to incredible financial outcomes for a few. However, the goal is to have the best of both worlds: Keep a good amount in the company stock to allow for additional appreciation while regularly selling portions to minimize your long-term risk and create financial freedom independent of the company.
Not Having a Plan to Exercise Your Options
Far too often, employees sign agreements for their stock options and then ignore or forget about them until it’s time to leave their company. This can be a huge mistake, especially when expiration dates or taxes are considered. Some employees forget to notify their tax preparer about exercising options or forget to include company stock sales in preparing their own returns. Stock options are often valuable assets and decisions need to be made within the context of your overall financial plan and objectives.
Another potentially expensive mistake is waiting until an IPO, acquisition, or expiration date to exercise vested options. In these instances, employees often use the “cashless exercise” technique, where some of the stock is sold right after exercising the options to cover the purchase of the entire lot. This could result in a larger tax bill since gains on the sale of stock would be treated as a short-term gain at a higher tax rate.
Ignoring the Tax Implications
Since the tax treatment of stock options differs, it’s essential to understand how receiving, vesting, exercising, and holding these options affect your tax situation. The differences not only apply to the stock acquired but could also influence how much tax you pay on your other income. For example, when exercising NSOs, the difference between the grant price and the exercise price is treated as ordinary income for tax purposes. This “extra income” is added to your earned income in the exercise year and could push you up into a higher marginal tax bracket, resulting in more taxes paid or having a nasty surprise at filing time.
For some employees, there are alternative minimum tax (AMT) considerations with exercising options. There may also be opportunities to select certain tax treatments to save on taxes in the future. For example, it may be advantageous and possible to use a Section 83(b) election to pay taxes at the time of the award, rather than wait until exercising the options.
Not Including Financial or Tax Professionals in Decisions
Considering the complexity of stock options and their impact on many aspects of your personal finances, it’s crucial to include your tax professional and an experienced wealth manager in any decision regarding stock options.
At Solidarity Wealth, we provide proactive (not reactive) solutions to help minimize your tax exposure and maximize your financial well-being. Since our team consists of former tax and estate planning attorneys and tax accountants, we are well-positioned to provide in-depth strategies and services that address your unique needs and objectives.
If you’re looking to craft a mindful, effective strategy that aligns with your personal aspirations, let’s have a conversation. Connect with us and let us help you realize your life vision.
About Jeff
For over a dozen years, Jeff McClean has advised some of the country’s most successful families on all aspects of their wealth. With his background as a former tax and estate planning attorney at a prominent Houston, Texas, law firm, Jeff has advised clients through business sales, funding rounds, IPOs, complex tax and wealth planning transactions, private and public market investments, executive compensation packages, succession planning, and much more. In short, Jeff helps clients navigate the unique challenges that come with building wealth and helps them better predict their financial future.
In addition to co-founding Solidarity Wealth, Jeff advises single-family offices on a broad array of challenges. He also serves as the Managing Partner of Solidarity Capital, an income fund managed separately by the Solidarity partners.
Jeff is a sought-after thought leader on a wide range of tax, finance, and estate planning topics. Jeff has been quoted in Yahoo! Finance and Kiplinger’s, has published in diverse publications from Silicon Slopes magazine to the Taxation of Exempts journal by Thomson Reuters, and has spoken to audiences ranging from the Estate Planning Section of the Utah State Bar to the Nonprofit Organizations Institute to large company conferences.
Jeff holds a bachelor’s degree in accounting from Brigham Young University – Idaho and a Juris Doctor, with honors, from the University of Texas School of Law. Outside of work, Jeff is married and the father of three amazing children. He has also served as past president of the Salt Lake Estate Planning Council.
Solidarity Wealth is a registered investment adviser. This material is solely for informational purposes. Advisory services are only offered to clients or prospective clients where Solidarity Wealth and its representatives are properly licensed or exempt from licensure. Past performance is no guarantee of future returns. Investing involves risk and possible loss of principal capital. No advice may be rendered by Solidarity Wealth unless a client service agreement is in place.
