When you work at a growth-oriented technology company, your finances and your income won’t be as simple as they are for others. While most people build their wealth from their salary, technology executives often build their wealth from their ownership in the company they work at in the form of stock options as part of an equity compensation package.
With the opportunity for higher growth potential on your stock options comes an added layer of complication both in terms of using them properly and planning for taxes. For instance, what type of stock options do you have? What are the different types of tax treatment for each option? What issues should you be aware of before implementing your stock options strategy?
To best understand those issues and more, here are five essential things to know about stock options.
1. Non-Qualified Stock Option (NSO)
An NSO is the most common type of stock option where the company grants the employee, and when the employee chooses to exercise them, they will owe ordinary income tax on the difference between the price they exercise and the price they were granted (this difference is commonly called “The Spread”). Since The Spread is treated as W-2 income, the exercise is subject to ordinary income taxes and FICA tax.
These options offer employees an additional type of compensation while allowing flexibility in terms of when to exercise and pay the tax on exercising them. After exercising them, the employee can choose to sell the shares immediately or hold on to them in hopes of further price appreciation.
2. Incentive Stock Options (ISO)
An ISO is a more complex type of stock option than an NSO and allows for special tax treatment as long as certain IRS requirements are met. Unlike the NSO, with an ISO you do not need to pay ordinary income tax at the time of exercising. However, there is a $100,000 limit on the aggregate grant value of ISOs that may first become exercisable (i.e. vest) in any calendar year.
Instead, if you exercise your shares and hold on to them for at least one year from the time of exercise, and two years from the time they were granted to you, then you would qualify for long-term capital gains tax rates, which are typically much lower than ordinary income tax rates. (1) One potential caveat, however, is that you may be subject to the Alternative Minimum Tax when you exercise these options. As the tax consequences are complicated, it is highly recommended you reach out to qualified wealth managers and tax experts to implement the best plan.
While you may see stock options as part of your overall compensation, that doesn’t necessarily mean that you own them when you join the company. Typically there is a vesting schedule that outlines when the stock options are granted to you, at which point you will be able to exercise and sell them.
While every company will have a different vesting schedule, one common example is a four-year vesting period. This means that an employee will receive 25% of their options every year, which incentives them to stay for four years to receive the full amount. (2)
4. Bargain Element
The bargain element is simply the difference between the price you exercised your shares for and the price at which they were granted to you. (3) The bargain element is essential to calculate as it will be used to determine whether, and how much, you will owe on your alternative minimum tax (AMT). Put simply, the higher the amount of your bargain element, the more likely you will be to owe AMT.
One potential strategy to consider is to exercise up to the point where you will owe AMT, but ensure you do not go above that. Alternatively, you may decide the extra taxes due are worth exercising your shares. As previously stated, careful planning and diligence are necessary to ensure your options strategy aligns with your goals.
5. Clawback Provisions
Most stock option agreements include a special provision that allows the companies to redeem options from employees even if they were already vested. This is known as a clawback provision, and the purpose of this provision is to provide some kind of remedy for the company if an executive has engaged in questionable legal or ethical actions.
However, that is not always the case, and companies like Skype have previously used the clawback provision for many employees even when there was no unethical behavior. (4) While analyzing your company stock options, review any clawback provisions in the options agreement so you know when and how they can be used.
Making Sense of Your Stock Options
If you have stock options at your company but don’t have a plan in place to best utilize them, we’d be happy to help. Reach out to us at firstname.lastname@example.org or call 385-374-1665 to schedule a discovery call.
Jeff McClean is a co-founder, partner, and wealth advisor at Solidarity Wealth, a privately held, independent wealth management firm that serves as a multi-family office to some of the Mountain West’s most successful families, technology entrepreneurs, and executives. He specializes in helping clients navigate the unique challenges of significant wealth and better predict their financial future.
As a former tax and estate planning attorney, Jeff is uniquely qualified to advise clients on their overall wealth to help them understand how the pieces of their financial puzzle fit and work together to meet their goals and build the best plan for their future. He values building personal relationships with clients and offering recommendations as a trusted partner, focusing on helping them grow in their financial confidence and freedom to choose their path.
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, he is a huge sports fan and enjoys spending time with family, golfing, and skiing. He also serves as President of the Salt Lake Estate Planning Council and is a frequent speaker on tax and estate planning topics. To learn more about Jeff, connect with him on LinkedIn.
This material was created to provide accurate and reliable information on the subjects covered but should not be regarded as a complete analysis of these subjects. It is not intended to provide specific legal, tax or other professional advice. The services of an appropriate professional should be sought regarding your individual situation.