How Advisors Help Clients Exercise Stock Options

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Although typically associated with startup companies, equity compensation has become increasingly popular as part of an employee’s overall compensation package. Financial advisors can help their clients understand their equity compensation and help them make decisions as they incorporate this benefit into their overall financial plan.

The most common types of equity compensation are stock options and restricted stock units, or RSUs. Stock options fall under two general categories: Non-qualified stock options, or NSOs, and incentive stock options, or ISOs.

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It is important for advisors to understand some of the jargon as they advise their clients. Some of the more common terms found in the documents provided to employees are as follows:

Issue date: The date the employer provides the stock options to the employee.

Grant price: The pre-set price the employee will pay for the company stock or option. This is also sometimes referred to as the “exercise price” or “strike price.”

Exercise date: The date the employee purchased the company stock at the grant price.

Expiration date: The date at which point the employee could no longer exercise their options if they have not done so.

Vesting schedule: The period of time over which the employee earns their options or shares.

Cliff: The date on which the employee can first exercise the right to buy their stock options.

Bargain element: Also known as the “compensation element.” The “spread” or difference between the exercise price and the market price.

Clawback provision: When certain conditions are met, the employer can recall the options.

Financial advisors can help clients understand their stock options by explaining the terminology, how their stock options work, and the tax implications of exercising and selling their options, in order to help them make the best possible decision as it relates to their overall financial plan. Here’s a rundown on the three most common types of equity compensation included in employee compensation packages:

— Non-qualified stock options (NSOs).

— Incentive stock options (ISOs).

— Restricted stock units (RSUs).

Non-qualified Stock Options (NSOs)

Non-qualified or non-statutory stock options give the recipient the right to purchase a certain amount of shares at the predetermined grant price. In addition to employees, these can be granted to others outside the company, such as consultants and members of the board of directors. They do not receive any special tax treatment; therefore, employees must pay ordinary income taxes on the bargain element.

For example, if the grant price is $20 per share and the market price is $40 per share, an individual that exercises 100 shares will pay ordinary income taxes on the $2,000 gain — which is calculated as $40 – $20 x 100. In addition, once the shares are sold there may be short-term or long-term capital gains if sold at a profit, based on how long they were held.

Incentive Stock Options (ISOs)

Also known as statutory stock options, these receive preferential tax treatment as compared to NSOs and are only issued to employees. Once vested, employees have the right to purchase a certain number of shares at the exercise price and typically have a 10-year time period before they expire. If the employee leaves the company, there is typically a 90-day window to exercise the options as ISOs; otherwise, they lose their special tax treatment and convert to non-qualified stock options.

The tax benefits of ISOs are significant. Employees can exercise their options after the stock price has risen, and not pay any income tax on the difference between the market price and the exercise price. There is no income tax to be reported at the grant date or at the exercise date. In addition, if the shares are held for at least one year after they were purchased and two years after the grant date, the options can be sold and the profit is taxed as a long-term capital gain.

However, ISOs can potentially trigger the alternative minimum tax, or AMT. This is very important for advisors to consider when recommending to clients whether or not they should exercise their ISOs. The difference between the exercise price and the market value, the bargain element, is considered an income adjustment for AMT purposes. AMT rates are 26% or 28%, and there are taxable income exemptions for the AMT. For 2022, the exemption amount starts at $75,900 for single taxpayers and starts to phase out at $539,900. The amount is $118,100 for married couples filing jointly, starting to phase out at $1,079,800. This provides a great opportunity for financial advisors to collaborate with their clients’ CPAs in order to help them properly plan when to exercise and sell their stock options.

There are various options for exercising ISOs. In a cash exercise, the employee provides the cash to pay for the exercise. Some employers offer a cashless exercise, where options are simultaneously sold upon exercise in order to pay for the exercise costs, and there’s an option to do a swap by using company stock already owned to cover the cost of the exercise.

Restricted Stock Units (RSUs)

RSUs are different from stock options. The main difference is that you do not have to buy them. However, the market value of the shares received is taxed as ordinary income when received and reported on the employee’s W2 wages. It is common for the employer to withhold income taxes, including federal, Social Security, Medicare and state or local income tax. Although taxes are being withheld, it is important for financial advisors or their CPAs to help their clients determine if the taxes withheld are adequate as part of the tax planning process. Enough estimated tax payments should be made to cover clients’ expected overall income in the tax year.

The client may have an option to do an 83(b) election. This is a provision of the IRS code that allows the taxpayer to pay taxes at the grant date instead of the vesting date. This provides an opportunity for clients to pre-pay their tax liability at a low valuation, but it can backfire if the value of the stock declines because the client will have overpaid their taxes based on the higher stock valuation.

RSUs are restricted because they are subject to a vesting schedule, but once vested, stocks can be treated just as if they were purchased in the open market and subject to short-term or long-term capital gains once sold, based on how long they were held.

Unless the value of the stock goes to zero, RSUs are almost always worth something.

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