Disclaimer: While the following article addresses many of
the common issues relating to executive stock option plans, there are a number
of considerations that can be specific to your employer’s plan or, more
importantly, your personal tax or financial situation. We would suggest that you contact
Beacon Financial Strategies or your tax advisor
prior to making any decisions relating to your executive stock option exercise
strategy.
There are a number of tax and other financial planning
considerations for those who have been granted executive stock options. The following article discusses the most
common types of executive stock options and their tax implications, including
possible exposure to the alternative minimum tax (AMT).
Non-Qualified
Stock Options (NQs)
Generally, the taxation of non-qualified stock options (NQs)
is considered less advantageous than their counterpart, the incentive stock
option (ISOs). Non-qualified stock
options give an employee the right to purchase company stock at a specified
price. Usually, an employee is granted
the option of a certain number of shares.
These shares gradually vest over a period of time (normally several
years). Non-qualified options generally
expire no more than 10 years from the grant date. Employees have the ability to exercise their
vested stock options at any time until the expiration date. The tax implications of non-qualified stock
options are as follows:
- When
the options are exercised, they are also sold on the same day. The difference between the exercise
price and the price on the date of the exercise is considered compensation
income and will be reported on the employee’s W-2. Because this income is considered
compensation, the income will be taxed at ordinary income tax rates.
- In most cases, the employer will withhold taxes on the income from the option exercise at a standard tax rate. Tax withheld includes, not only federal and state withholding, but also Medicare and Social Security.
While the employer does withhold taxes from the option
exercise, we have found that in many cases the withholding levels are
inadequate. Remember, the tax liability
generated from the transaction is dependent on an employee’s specific tax
bracket and not the employer’s standard withholding schedule.
Incentive Stock
Options (ISOs)
Incentive stock options are similar to non-qualified stock
options in the way they are granted to employees and their vesting schedule. However, those individuals with ISOs should
carefully consider their exercise alternatives and the inherent tax
implications when developing an options exercise strategy. The taxation of ISOs, depend on whether the
options are exercised and the stock is immediately sold or if the stock is
retained. Consider the following:
Option is exercised and shares
are immediately sold
An employee can choose to exercise
the ISO and immediately sell the shares.
In that case, the difference between the exercise price and the market
price would be taxed to the employee at ordinary income tax rates (the same as
a non-qualified stock option).
Generally, the employer is not required to withhold taxes on this type
of transaction.
Option is exercised and shares
are held
An employee can also purchase the shares at the specified
option price and hold them for as long as they choose. The following are tax considerations when
ISOs are exercised and shares are held:
- Taxation
on the options exercise date:
- Regular
Tax: There is no income
tax reported for regular tax purposes.
- AMT: When the shares are purchased, the
difference between the exercise price and the market price is a
preference item for AMT (Alternative Minimum Tax) purposes. As long as the preference item does
not trigger AMT, the purchase transaction would not trigger any
additional tax.
- Taxation
when shares are sold:
- Regular
Tax: When the shares are
sold, a capital gain is reported as the difference between the exercise
price and the sales price. If the
shares were held for at least one year, long term capital gains rates
would apply.
- AMT: When the stock is subsequently sold,
there is a negative AMT
adjustment equal to the difference between the exercise price and the
market price on the date of purchase.
Restricted Stock
Units (RSUs)
Restricted Stock Units are a relatively new form of stock
compensation. Basically, a company grants
a specific number of shares to an employee with a future vest date (generally
2-3 years away). On the vesting date,
the stock is valued at the current stock price.
The total value of the stock on the vesting date is reflected in the
employee’s compensation and therefore taxed at ordinary tax rates. A portion of the shares are sold to pay for
the withholding for federal and state income tax as well as Medicare and Social
Security tax. The remaining shares are
issued to the employee.
The remaining shares can be sold at any time after they are
issued to the employee. At the point
shares are sold, any gains would be taxed at long term capital gains rates if shares
have been held for at least a year. The
capital gain is calculated as the difference between the sales price and the
price on the vesting date.
Example: An employee is issued 150 shares of
restricted stock units that will vest in two years. On the vesting date, the stock price is
$10/share. Therefore, $1,500 is included
as the employee’s compensation.
Withholding for federal and state income taxes and Medicare and Social
Security is assumed to be $500.
Therefore, 50 shares are "sold” to pay for the tax withholding and the
employee is issued 100 shares of stock.
One year later, the stock price is $14/share and the employee decides to
sell the 100 shares of stock. The
proceeds from the sell are $1,400 and the capital gain from the transaction is
$400 ($1,400-$1,000).
For those executives
who have been granted stock options, there are a number of financial planning
and tax implications to consider.
Beacon Financial Strategies has extensive experience
in helping clients understand their stock options and develop a tax-efficient
exercise strategy. For more information,
visit www.BeaconFinancialStrategies.com
or contact our office at (919) 321-8625.
Beacon Financial Strategies is an independent
financial planning, tax and investment advisory firm located in Raleigh, NC.
Beacon works with clients on a consultative and objective basis to help them
achieve their personal financial goals. Beacon professionals specialize in the
following areas of financial planning: retirement feasibility planning, estate
planning and coordination, tax minimization strategies, and wealth management
services.
Beacon
Financial Strategies provides both one-time and ongoing
financial planning, tax and investment advice to clients and operates in a
fee-only, fiduciary capacity.