Navigating Your Employee Stock Options
Stock options can generate various unanticipated consequences, especially tax treatment. In the world of tax, you cannot always control the timing or the effective rate of certain items and investments. When a bond pays interest, or a stock a dividend, or a fund has a realization event, the tax impact can be outside of one’s control. But what about stock options? Stock options are no longer privileged to key executives and founding employees. Increasingly private and public companies are offering employee-stock-option-plans (ESOP) as a method to retain and compensate all types of employees. Options typically provide you with, well…options. Whether they are Incentive Stock Options (ISOs), Nonqualified Stock Options (NSOs), Restricted Stock Units (RSUs), or other alternatives, it is critical to understand the tax implications, not just for tax efficiency, but also within the context of one’s greater investment allocation, diversification (or portfolio risk) and cash management.
Proactive planning and understanding the impact of what you “can do” provides more control, which is preferable to being reactive and dealing with the implications of what you already “have done”. Predicting the future of markets is difficult—predicting the vagaries of a single stock is near impossible. Maintaining flexibility with a thoughtful plan can provide opportunities for further efficiencies and allow one to make better-informed decisions. Our role at Silvercrest is to help our clients understand the “can-do” while collectively finding solutions to the “have done”.
Incentive Stock Options (ISOs)
Grants employees the right to buy shares of company stock at a discounted price with added tax benefits of profits. Creates taxable, ordinary income upon exercising the option for alternative-minimum-tax (AMT) purposes.
Exercising & Selling ISOs
- No tax liability on the date the options are granted
- No regular tax liability if a previously granted ISO is exercised
- No regular tax consequence when the option is exercised
- AMT implications need to be addressed
Non-qualified Stock Options (NSO)
Create taxable, ordinary income in the year it is exercised, for both regular tax and AMT purposes.
Exercising & Selling NSOs
- Income is typically equal to the excess of the stock’s fair market value on the date of exercise over the exercise price plus any amount that was paid for the option
- Recognized upon exercise will be taxed as compensation and flow through to an employee’s Form W2 (subject to both Social Security and Medicare tax withholdings)
- Potentially problematic to produce the funds needed to exercise options
- After exercising, any appreciation/depreciation in the stock’s value will be taxed as capital gains/losses
- The holding period for the underlying stock starts when the shares are exercised—it does not include the time the option
- Shares with gains disposed after more than one-year are taxed at long-term capital gain rates
Types of NSOs
Restricted Stock Units (RSU)
- An award of stock units that is restricted until vesting requirements are met
- Not taxable until vesting is complete
Restricted Stock Awards (RSA)
- An award of stock units that is restricted until purchase price requirements are met
- Taxable at the time of grant
Stock Appreciation Rights (SAR)
- An award of shares or cash equal in value to the appreciation of company stock over a specific period of time
- Taxable once exercised
In mid-December 2021, a prospective client (who we will refer to as Mary) approached Silvercrest about her option plan. Her company had recently gone public, and, over the years, she had accumulated a meaningful mix of ISOs, NSOs and RSUs. Mary’s company offered these various options as alternative compensation and to allow employees to uniquely benefit in the growth of the company. However, like with many companies, at no point did her employer explain the differences between the various options and the separate tax consequences. Through word of mouth, Mary “heard” it `was advantageous to exercise and hold ISOs, thus starting the proverbial “clock”, such that in one-year the options could be sold and receive the favorable long-term capital gains tax rate (versus ordinary income rates). As Mary put it, she “clicked a bunch of buttons” throughout 2021, with the intention of starting the clock on the ISOs. The question Mary thought she wanted to understand was what her tax liability would be when she sold the options after one year and how Silvercrest may be able to assist.
What Mary did not understand was that when you exercise and hold an ISO it is not immediately taxable for regular income tax purposes on the federal side (and generally not taxable for state/local tax purposes). However, it does cause a taxable event for purposes of the Alternative Minimum Tax or AMT. We generally illustrate the regular income tax versus the AMT as a see-saw. We want the see-saw to balance, to the extent possible, being as efficient as we can. Otherwise, additional AMT may be unnecessarily owed. In this case, Mary had an extremely concentrated position, with limited cash. She had not realized that when she exercised and held her ISOs that she triggered a major, cashless tax because of the AMT. Thus, putting our see-saw out of balance by weighing down the AMT side—Mary was shocked and overwhelmed. While late in the year, for 2021, Silvercrest was dealing with a “have done” situation.
We worked with Mary to quickly understand her issue, reduce the amount of the “cashless” tax liability and identify a tax-efficient strategy. In effect, we wanted to better balance the see-saw by generating regular income tax, which would provide the cash to cover her future tax payment.
Since the start of 2022, we continue to work with Mary and develop a multi-year strategy based on her current options and expected future option grants. We have been proactive, helping her to understand what she “can do”. Further, Mary has broadened her relationship with Silvercrest’s Family Office Services Group. While having a multi-million-dollar option plan, Mary had not considered estate planning or long-term financial and retirement planning—additional services that Silvercrest provides.
On the Investment Advisory side, we have helped Mary to better define the needs and objectives required from her investment portfolio. Together we reviewed her asset allocation and proposed various strategies that would help balance her portfolio against the inherent risks of a concentrated stock position.
Ultimately, we provided Mary with an investment proposal outlining her investment objectives, tolerance for capital loss (risk), income needs (liquidity) and relationship expectations. Our initial allocation took into account her entire balance sheet, including assets that would not be managed directly by Silvercrest e.g. stock options, 401(k) plan, and direct venture investments. In this example, Mary’s company would be considered a high-growth stock, thus we agreed that the investments managed by Silvercrest would provide sufficient flexibility and could be altered in accordance with the capital markets and her personal circumstances. More specifically, we constructed two portfolios consisting of tax-exempt fixed income securities, producing much-needed cashflow, and high-quality, value-oriented stocks. In addition, we helped her to re-balance her current 401(k) plan, such that the underlying investments dovetail with her overall portfolio.
Working in concert with Mary and our Family Office Services Group, we have established a plan to incrementally reduce her single stock position. A portion of the proceeds from the ongoing stock sales will be held in a separate tax-escrow account, allowing Silvercrest to directly pay her quarterly tax payments. Also, excess proceeds can readily be deployed as we continue to invest her taxable portfolios.
In Mary’s case, it was important to first understand the tax implications of what she “had done” before transitioning to what she “could do”. Eventually, our conversations evolved to near-term investment planning and ultimately to discussions about long-term financial, retirement and estate planning. Mary went from a situation where she felt shocked and overwhelmed to feeling in control. In doing so, she is better able to make more informed decisions across her entire portfolio.
Options provide you with options, which can become headaches—if not handled appropriately. We encourage all who hold options to take inventory of the type of option they own and to be proactive in their approach—Silvercrest welcomes the opportunity to assist you.