Employee Stock Ownership & Options

Key Takeaways:
  • Company stock plans & stock options have many customizable details
  • Employees should understand their stock plan’s features & tax consequences
  • With correct utilization, employee stock can meaningfully increase compensation

When evaluating a job offer, it is best not to focus only on salary or an hourly wage.  We have the pleasure of speaking to MBA students each year and it seems like this is the biggest slip-up in job searches and compensation negotiations; you have to include benefits to get a true apples-to-apples comparison.  Financial pieces like a retirement plan or stock plan, and non-financial inputs like remote work flexibility and the availability of a committed mentor affect not only how your finances look this year, but how your career and long-term retirement picture take shape.  

We begin our focus on employee benefits with company stock plans.  Many flavors can be customized in myriad ways, so each plan is unique.  If you have the opportunity to participate in company ownership, our advice is the same for any other investment or asset – know what you own.  Employee owners should evaluate their ownership each year, the stock’s performance, their tax picture relating to the holding, and their plan of action.

Employee Stock Ownership Plans: The Most Common 

The most prevalent type of stock benefit is the Employee Stock Ownership Plan (ESOP).  Companies use grants (a sale of company stock to employees) to incentivize employees as owners, finance company operations, and augment employee benefits without additional cash.  The usual setup is for the company to grant some amount of profits into the plan which is then allocated by employees proportionally to their salaries.  Employees need to be aware of vesting periods and the stock price.  For companies with underperforming stock, employees may want to sell as soon as allowable.  At high-performing companies, employees often build a substantial portion of their wealth in stock ownership.  This presents a huge planning opportunity called the Net Unrealized Appreciation (NUA) strategy,  in which the employee pays income tax on the original cost basis, but then pays lower capital gains rates on the appreciation.

Non-Qualified Stock Options: Options for the Entire Company

An alternative to granting full shares of the company stock is giving employees the option to purchase shares.  These plans are generally made available to all employees with a minimal service requirement.  Employees are allowed to purchase a set number of shares at a preset price (grant price) until some expiration date.  They pay income and payroll tax on the spread between this grant price and the market value upon exercise, even if they continue to hold the stock.  These employees will want to understand this tax liability as it may create “phantom income”; they have tax liability upon exercise but if they hold the stock there is no corresponding cash to pay the tax.  Options can also be subject to vesting or clawback, so keep an eye on these provisions and read the fine print if evaluating other job opportunities.

Incentive Stock Options: Executive Compensation

Non-qualified stock options (NSOs) get their name because they don’t qualify for the preferred tax treatment that Incentive Stock Options (ISOs) enjoy.  ISOs require a holding period of two years between grant and exercise, and then an additional year of holding the stock before sale to get preferable tax treatment at capital gains rates.  This means that if an employee prematurely sells, they lose this treatment and pay ordinary income tax, effectively turning their ISO into an NSO.  Due to the additional holding period, this setup is usually used for executives and highly-compensated employees of public companies or companies about to become public.  With its favorable tax treatment, the extra holding period presents a trade-off with more holding risk for the employee.

Restricted Stock & 83(b) Elections

A final type of equity compensation is restricted stock, equity that cannot be sold until a vesting schedule is completed.  Recipients of restricted stock have a timely decision to make, as they can utilize an 83(b) election to pay tax on today’s value for shares that will vest in the future.  That creates an opportunity for large tax savings but also a loss if the shares don’t appreciate.  This decision warrants extra attention in a sluggish equity market like we are experiencing in 2022.

No matter the type of stock benefit presented to you, the best course is to spend ample time understanding your risks and opportunities on the front end.  Then a watchful eye on the stock performance and a periodic review of your tax position can help lead you to make the best decision at each step.  We are happy to help our clients understand and plan around these benefits by request.

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