By: Kyle Euton
Posted: 3/25/2024

Whether or not you have ever been fortunate enough to be a stock award holder for your company, you’ve likely seen headlines about executives who have. Those from Fortune 500 companies who have sold an enormous quantity of shares or received a large compensation package that included stock options. So, what exactly are stock options and what role can and do they play in compensation plans?  

You don’t have to be a corporate executive to receive options and other stock awards. In fact, many public and private companies today are utilizing stock more frequently to compensate their employees. Equity compensation is commonly used to retain and attract top talent and it provides a financial stake in the company to further align the employee and company interests.  

Your equity compensation package may not compete against the likes of Elon Musk, but it can still make up a significant percentage of your investable assets. Having a firm understanding of concentration risk, liquidity, and tax implications are just a few items that can help manage and maximize these benefits. Here’s a brief description of two common award types and a glimpse of how we conceptualize equity compensation with clients.  

Restricted Stock

Restricted Stock is an award type where an employee receives a grant of stock that distributes over time, typically referred to as a vesting schedule. The vesting’s are usually proportionate, occurring at least once a year. Shares are not available until each tranche is distributed. Once a vesting occurs, the employee recognizes income and payroll taxes are withheld, just like a paycheck. As a result, the transaction is automatically accounted for on the employee’s W-2 tax form.  

The recognized income is simply derived from the stock price multiplied by the number of shares. If 1,000 shares vest and the stock’s trading at $10 per share, the employee recognizes $10,000 of W-2 income. After payroll taxes (Federal, State, FICA), a net quantity i.e. 700 shares would deposit into the employee’s brokerage account.  The employee’s cost basis is now $10 per share or “fair market value” at the time of vesting. From here, the shares act like any other stock position you’ve acquired in the past, where short and long-term capital gains/losses apply when sold. 

The question becomes, when do you sell? We encourage clients to view each restricted stock payout as a cash bonus and we pose the following question to help visualize the situation.  

If you received a $10,000 bonus check today, would you then turn around and buy your company stock?  

If the answer is no, then sell the net shares once they’ve been received and pocket the proceeds as take-home pay. If you hold shares and decide to sell later, the share price may be lower. Unfortunately, you will have paid taxes on an amount greater than what you received.  

The opposite can also be true, where you pay favorable long-term capital gain rates if you sell above your basis, but you must hold the stock for at least 1 year past the vesting date. Do you know with any certainty that the stock price will be higher one year from now? In other words, if you decide to hold vested shares, you’re stating your company stock is the best use/ investment available for your “cash bonus”. 

Stock Options

Stock Options give the employee the right to purchase company stock at a predetermined price. The set price is known as the grant price and is commonly referred to as the “strike” price. Like restricted stock, options are awarded in grants which have a vesting schedule.  When an option tranche vests, the employee has the right to purchase the specified quantity at their grant price. However, unlike restricted stock, option grants have an expiration date, generally set at 10 years from the original grant date. 

It only makes sense to purchase (exercise) the grant if the strike price is below the current market value. If that’s the case, the option is referred to as being “in-the-money”. If not, the option has no value “out-of-the-money” and you’d be better off purchasing shares on the open market at the lower trading price. Option grants can and will expire worthless if you haven’t exercised and the market value doesn’t exceed the grant price. 

Common exercise types: 

  • Exercise and Sell – Shares of stock are purchased, then immediately sold on the open market. The proceeds from the sale are used to cover the grant price costs and tax withholding (if applicable). The net cash remaining is then deposited into the employee’s brokerage account. This is known as a “cashless” exercise, meaning no out-of-pocket costs are needed from the employee/option holder to perform this transaction. 
  • Exercise and Hold – Purchase stock with cash and cover tax withholding (if applicable) and receive the gross quantity of stock. 
  • Exercise and Sell-to-Cover – Shares are purchased, then an adequate number of shares are immediately sold to cover the grant price costs and tax withholding (if applicable). This is also a “cashless” transaction with no out-of-pocket costs and the employee/ option holder receives a net quantity of shares.   

Finally, there are two categories of stock options to be aware of – Nonqualified Stock Options (NSOs) and Incentive Stock Options (ISOs). With nonqualified options, you recognize income and pay tax at the time of exercise, no matter the exercise type. Once exercised, the W-2 income and tax reporting is just like restricted stock. The only difference is that the income is derived from the difference between the grant price and current market value, known as the “spread” or “bargain element”.  

NSO Exercise Example:  

  • Grant “Strike” Price = $100  
  • Current Market Value = $150  
  • Exercisable Quantity = 1,000  
  • Recognized Income = $50,000 ($150 – $100) x 1,000 quantity 

We tend to view NSO exercises through the same lens as a restricted stock, transact to receive cash as income and payroll taxes are then recognized.  When considering an NSO exercise, clearly the stock trading price is top of mind, but also be mindful of your overall income for the year and time remaining (time value) on your option grant.   

Regarding ISOs, there’s potential for preferential tax treatment when purchasing the stock (Exercise and Hold). The employee can purchase stock at the grant price and if shares are held two years from the grant date and one year from the exercise date, long-term capital gain rates apply to the “spread” instead of ordinary income rates like NSOs.  

In addition, when you purchase stock through an ISO grant, you only cover the grant price costs, there’s no automatic tax withholding and you do not recognize income at the time of exercise. The employee will only recognize income if you sell any portion of the stock before the holding requirements are met, also known as a disqualifying disposition. Alternative minimum tax (AMT) can be a factor with this type of transaction, however, PDS can work with you and your tax advisor if applicable.  

If you have questions about or are looking for help with maximizing and understanding your equity compensation, please contact us at PDS Planning. The collective experience of our expert financial planners and advisors will confidently outline the details and revise your comprehensive financial plan accordingly. Being a recipient of your company’s equity compensation package is an integral part of the financial plan and should be reviewed and confirmed continually. 

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